FICO Mythbuster #345, Paying Off Installment Debt Will Improve Your Scores

I’ve been telling people for years that installment debt is not terribly important when your FICO scores are concerned. And for years people have been looking at me like I’m crazy. Debt is debt, right? How in the world can it not matter? In this installment of FICO Mythbusters, I’ll reiterate my statement and provide a personal example.

First off, what is installment debt? There are three types of debt: installment, revolving, and open. Installment debt is a fixed payment for a fixed period of time. For example, an auto loan is installment debt. You pay some amount each month for a fixed number of months. Mortgages are installment debt. You pay the same mortgage payment for some fixed period of time.

Installment debt is generally secured by real property. Auto loans are secured by your car. Mortgages are secured by your home. And if you stop making your payments, the lender will simply come take your car or kick you out of your home. Either way it’s a bad situation, so consumers tend to work harder at paying their installment loans on time. I mean, who wants to get kicked out of their home? What this means in the world of credit scoring is that installment debt tends to be much more stable than unsecured debt, debt which allows no repossession options.

This means installment debt, while it still does count in your credit scores, isn’t driving your scores one way or the other like credit card debt can. The upside is buying a new home and getting into several hundred thousands of dollars of debt generally doesn’t have that much of an impact to your scores. The downside is that paying off the debt doesn’t really help your scores that much either.

For example, I just sold a home. The loan on that home was $224,317 from Wells Fargo Mortgage. Yesterday that loan was updated on my credit reports to show “Paid in full.” I went from having an installment debt of almost a quarter of a million dollars to having it paid in full. The impact to my FICO score?: 4 points to the positive.

This is exactly why people who ask me if paying down their mortgage or car loans faster than required will help their FICO scores. No!! For those of you who have the extra cash each month and are contemplating an acceleration to pay down your installment loan, be advised that it will not result in a material score improvement. Paying down credit card debt: Yes, this is the answer! Paying down car loans and mortgages: No!

So, there you have it. We’ve busted FICO Myth #345. Take your extra money and pay off credit card debt or work to build your retirement nest egg. Leave those mortgages and car loans alone. By paying them on time each month, you’re pretty much getting maximum score value.

John Ulzheimer – Credit scoring and credit reporting expert and author, John is the President of Consumer Education for Credit.com. Formerly with Equifax and Fair Isaac, John shares his unique insight of the inner workings of credit scoring models and the credit reporting industry on CreditBloggers.com.

Comments

[JDL]

I have the opposite problem. According to my credit.com report, I get a C in one category because I DON'T have an auto loan or student loan. It said I need a better mix of loans. I've got a home loan and credit cards, so I'm not sure why I'm penalized for not having auto and student loans. I'm tempted to find some tiny loan of that type to see what, if any, effect it has on my score.

[JohnUlzheimer]

JDL, but is your FICO score good overall? I wouldn't suggest getting a loan simply to see what it does to your score. What if you don't like the result? It would be too late to turn back.

[JDL]

John, my score is good, could be better. You have a good point. I'd really prefer to know why not having an auto and student loan (but lots of other loans) is a detriment to one's score.

[Melissa]

I have a question. I have $12,000 on a revolving loan at 21% (payment is $210 and interest is $200), and about $50,000 in other credit card debit at about the same APR. Anyway I've come into some money and have about $6,000 that I can either pay down on the revolving or I can payoff 3 other credit cards. Which is the better option? Thanks, Melissa

[JohnUlzheimer]

There are two answers to your question Melissa. From a purely financial
perspective you should compare the interest rates youre paying on your
loan (21%) versus the rate youre paying on those 3 other cards. If the
21% is higher then pay down the loan.

From a strictly credit scoring perspective you should pay off the credit
cards. And then leave them open.

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Mythbuster #345, Paying Off Installment Debt Will Improve Your Scores