Take a Strategic Approach to Paying Off Debt

by: holli casto
vp of training and development
Published 8/21/2024

Paying off your debt is a fantastic goal for countless reasons. It frees up money each month that would otherwise go towards payments and improves your credit score by lowering your credit utilization.

If you're unsure where to start with your payoff journey, we recommend taking a strategic approach to your payments. When you allocate extra money towards your payments, be intentional about where you put those extra payments to effectively pay down your debt.

How to Prioritize Your Extra Payments

When you have more than one payment, choose one bill and dedicate your extra money to that payment while continuing to make minimum payments on your other loans. This approach will pay off that debt faster, freeing up the money you have for that minimum payment more quickly. Once that loan is paid off, use the money you were putting toward that payment for your next loan. Repeat this process until all of your loans are paid off.

This method is more effective than spreading out extra payments across all of your loans because it frees up your cash sooner to dedicate to other payments. Keep the amount you have budgeted for debt repayment the same until all of your debt is paid off. This way, the amount you’re paying towards your bills gets larger and larger despite your budget for debt repayment staying the same.

Consumer Credit Card Debt is at an All Time High

Average Credit Card Debt by Generation, 2014-2024

Which Payment Should You Prioritize First?

Now that you know how to approach your payoff, deciding which payment to prioritize first is the next question. There are two popular methods: the snowball and avalanche methods.

The Avalanche Method prioritizes paying off your debt with the highest interest rate first, reducing the amount of interest paid over time.
The Snowball Method involves choosing the loan with the lowest balance first, allowing you to pay off bills quickly and gain motivation from early successes.

Both methods are effective at paying off your debt. Choose a plan, stick to it, and free up each payment to dedicate to your next bill.

How Paying Down Debt Affects Your Credit Score

Paying off debt will have a long-term positive impact on your credit score. This is because your credit utilization will come down, which makes up 30% of your credit score.

That said, paying off debt does have a complicated effect on your score. If you're paying off installment loans, zeroing out your loans may hurt your score if it was also your only installment loan because it will show you have less diverse credit.

If you pay off a credit card, avoid closing the card because this will hurt your credit history and utilization. Closing the card will reduce the amount of credit available to you, hurting your utilization. Furthermore, closing the card will negatively impact your credit history and age—your goal is to have old accounts, and closing cards will not help that.

Even if you don't pay off all of your debt but bring your balances below 30% utilization, your score will improve significantly.

Utilization is weighted more heavily than credit mix or age, so bringing down your utilization and paying off loans will have a more significant impact on your score in the long run.

What is Credit Utilization?

Credit utilization is the ratio of your outstanding credit card balances to your credit limits. For example, if you have a credit card with a $10,000 limit and your balance is $3,000, your credit utilization rate is 30%. This percentage is a critical factor in your credit score calculation. High credit utilization can indicate a higher risk to lenders, as it suggests you are heavily relying on credit. To maintain a healthy credit score, it's recommended to keep your credit utilization below 30%. Paying down your debt reduces this ratio, signaling to creditors that you are managing your credit responsibly.

How Consolidation Loans Affect Your Score

If you’re working on paying off debt, then debt consolidation has probably crossed your mind as well. Debt consolidation is a financial strategy that involves combining multiple debts into a single loan, often with a lower interest rate. This can simplify your repayment process by reducing the number of payments you need to manage each month, potentially lowering your overall monthly payment and making it easier to pay down your debt.

You can use personal loans, balance transfer cards, home equity loans, or other types of capital to refinance your debt into a consolidation loan. It all depends on your credit score and financial situation.

The impact a consolidation loan has on your credit score is complicated but tends to be positive. Taking out a consolidation loan will lower your utilization on your cards, which is one of the biggest factors when calculating your score because you have a whole new credit line but the same amount of debt.

The negative effects will be that you have a new credit line, decreasing the average age of your credit accounts, and you have a new credit inquiry on your report. These are important parts of your report, but if your utilization is hurting your credit score the most, lowering your utilization will outweigh these other two actions.

The more important issue to consider with debt consolidation is making sure that once your cards are paid off, you don’t rack up a balance again. Whether this means not using your cards at all until you pay off your consolidation loan or practicing only using your card for what you need and paying it off, make sure that once your available balance is freed up, you don’t spend even more.

Another mistake we see several people make with consolidation loans is that once their balance is zeroed out on their credit card, they close the account. While this may be tempting to avoid using the card, this will hurt your credit score even more than taking out the consolidation loan did.

As we mentioned above, closing your credit card accounts will hurt your score because you’ll be decreasing the number of accounts you’re managing and the average age of your accounts. If you’re worried about using your cards, find a safe place out of sight to store them. You will need to exercise reduced spending in the long term, so this is a good place to start.

Paying Off Debt Will Help in Other Areas of Your Life Too

While the financial advantages of reducing debt are obvious, we often overlook the profound psychological benefits that come with it. Managing your payments strategically and seeing your balances diminish can significantly boost your mental well-being by alleviating stress and anxiety.

So What?

Paying down debt and improving your credit score is a long game. Making a plan that you can stick to is key to your success. Each step you take brings you closer to a life with less stress and more opportunities.

As you follow your strategic debt repayment plan, remember that it's not just about the numbers. It’s about the confidence and control you gain over your financial future. Each payment you make is a step towards not only improving your credit score but also enhancing your overall quality of life.

The journey may have its challenges, but with determination and a clear strategy, you can overcome them. Celebrate each milestone along the way, no matter how small. Recognize the progress you’re making and use it as motivation to keep going.