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Friday, August 13, 2010

Pay Down Car Loan vs. Pay Down Credit Card Debt

Dear Katrina:

I have been working to improve my credit score by paying down my debt so my wife and I can finally buy a home.  Last month we were really excited and proud of ourselves for paying off one of our vehicle loans and have been eagerly anticipating the bump to our scores. 

As you suggested, we have been subscribed to Equifax's Credit Watch.  The other day we received the alert that the loan had been paid in full.  We were surprised and extremely disappointed that there was not a boost to our credit score.  We can't understand this at all.  We paid off one of my wife's credit cards that was maxed out and it boosted her score almost 50 points.

Why didn't our credit score increase? What did we do wrong?

Mike and Kelly
Atlanta, GA

Dear Mike and Kelly -

You did not do anything wrong and in the long run you did something very right.

Your first question was why your score did not increase.  Paying down an installment loan such as a car or motorcycle loan, usually results in little or no increase in a consumers credit score.  Why?  Quite simply, credit scores don't give much weight to a paid in full account.  Scores give more weight to timely payments and amount of credit you have available to you.  By paying off an installment debt on time or early, you did not extend your payment history or open up any additional credit to yourself, like you did when you paid off one of your wife's credit cards.

This does not mean you did something wrong though.  You stated that your ultimate goal is to purchase a home.  When purchasing a home there are two factors that lenders that you have control over, your credit score and your debt to income ratio.  

By paying down an installment loan (car, motorcycle, etc) you have decreased your debt to income ratio, which is a good thing.  Lenders take the monthly debt you owe and divide it by your monthly income to determine your ratio.  The lower your debt ratio is, the better you look to a potential lender. 

Be sure to speak with your mortgage broker about where your credit score and your debt to income ratio needs to be for the loan guidelines you will be applying for.  Together you can come up with a targeted plan to get you where you want to be financially for a smooth and easy loan approval and closing.

Keep up the good work!

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