Paying off your credit card all at once can raise your credit score. But if you receive a financial windfall, consider saving a portion and setting yourself up for long-term success.
If you find yourself with a financial windfall, you may be tempted to use it all to pay off your credit card debt. After all, paying off your credit cards will decrease your credit utilization to zero and get access to 100% of your available credit. Since credit utilization counts for 30% of your FICO score and is second only to paying your bills on time, your score should see a fairly immediate jump.
But before you throw the whole windfall at your credit card debt, take a minute to take in the big picture. Consider what caused you to end up with a balance so onerous that it took a large sum of money to dig you out. What would happen next month if an unexpected large expense showed up? Would you be forced to carry a large balance again and have your score suffer after only a brief respite?
If so, this is a great time to put a long-term plan in place. Here are a few things to consider:
Does carrying a balance help your credit score?
You may have heard you should carry a small balance on your cards to help your score, but that is simply not true. The FICO algorithm will not punish you for not carrying a balance on your cards. Not having a balance or paying one off in full is just fine with the score.
Along those same lines, if you simply bring your account balances down to about 20% or less, you will see a credit score increase. You can then try to pay off the remaining balance over the next six to nine months. Without a plan to pay your cards off entirely, you may keep a balance longer than you need to.
Is it better to pay in full or carry a small balance?
Consumers with excellent credit scores almost universally have credit utilization ratios in the single digits. So, keep that in mind. I would not suggest you continue to just pay a little more than the minimum on your cards. This is going to cost you more in interest payments and won’t have much of an immediate impact on your score.
The bigger question may be: What happens after you pay down your cards? See how much you will be able to reduce your balances using half your windfall. If you can drive your balances below 15% of your credit lines, I’d stop there and use the other half to establish an emergency fund.
Without an emergency fund, the next big expense may put you back in the position of using your cards to pay for it and then carrying a big balance from month to month. This is both expensive and bad for your score. At 15% or less, your balance won’t hurt your score and you’ll have a cash cushion to handle emergencies.
Estimate your spending and income so you have a handle on what is coming in and what is going out each month. Build in something for savings – even just a few dollars per pay period, if that’s all you can do. Whether your windfall is a bonus, tax refund or stimulus payment, a raise or inheritance, save half. In no time you’ll have a cushion and money to fund your goals, and you’ll feel financially secure.
When carrying a balance can hurt your score
One good reason not to carry a balance is to avoid credit card interest charges. But some cards offer low or even 0% introductory interest rates for a specific period of time, typically 12 to 18 months. Carrying a balance on a card like that may make good financial sense.
But it’s important to be prepared for the unexpected. If something unforeseen occurs, such as a medical emergency or job loss, you may be stuck with a large balance you can’t pay and end up making late payments. The utilization factor will remain, so be prepared for what that might do to your score.
When you should pay your credit card bill
One of those is to make several payments throughout the month. Another is to immediately pay off large purchases. Both are valid, but remember that however you decide to make your payments, the most important thing is to be sure payments in full are received by the date they’re due each and every time.
If you’re planning to apply for new credit within a few months, remember a very large purchase can affect your score quickly by increasing your credit utilization. In that case, paying off that purchase immediately might be the prudent thing to do. You will have the money available, right?
The lower your credit card balances, the less interest you pay and the better your credit score. But rather than throwing a one-time windfall at your credit card debt, come up with a plan first to keep those balances down. The best way to maintain a high credit score is to pay your balances in full on time, every time. That may require setting up a rainy day fund, so you can keep debt at bay and continue to build your credit.