In April 2020, UK households repaid a whopping £7.4 billion* of unsecured debt - the largest repayment since records began. So we investigate what impact paying off debt has on your credit score, and whether the type of debt makes any difference.
What is your credit score and why is it important?
Your credit score gives lenders an insight into how responsible you are with money. The better your financial history, the higher your score - and the less risky you appear.
To check your score for free, you can contact the three main credit reference agencies in the UK: Experian, Equifax and TransUnion. It isn’t set in stone, it goes up and down based on your financial behaviour. So there are things you can do to improve it.
There are many benefits to building up a good credit score. For example, you’ll have better chances of approval for all types of finance: from mobile phone contracts to mortgages. Plus, you may increase your eligibility for lower interest rates (depending on the lender’s criteria).
Will paying off debt improve my credit score?
One common credit score myth is that you should keep an outstanding balance on your credit card. In fact, the sooner you clear your debt the better. Your credit score will benefit and you’ll pay less interest.
You can improve your credit score by gradually paying off your debts on time, every time, or by paying them off with a lump sum of cash. Either way, it shows lenders that you’re a reliable borrower who can be trusted to make repayments.
The length of time it takes for your credit score to improve depends on a number of factors. For example, how good your credit history is to begin with, and how quickly you clear your debts.
You might also be surprised to learn that clearing credit cards and overdrafts has a more positive impact on your credit score than loans. We delve in to explain more...
Paying off credit cards and overdrafts
If you can’t afford to pay the full amount each month, you must pay at least the minimum payment. That way, you’ll avoid getting late payment markers on your credit report (and late fees). The more you pay, the quicker your debt will go down, but don’t overstretch yourself.
If you’ve managed to gather some savings, you could consider using them to pay your debt. This makes sense if you’re charged more interest on your credit card than you’re gaining on savings, for example.
Aim to reduce your borrowing to 25% or less of your credit limit. This will lower your credit utilisation ratio and improve your credit score. Your credit utilisation ratio is the percentage of the money you’ve spent out of your total credit limit.
To calculate your credit utilisation ratio, divide your total balances by your total credit limits:
For example, if you’ve got a combined balance of £500 and credit limit of £2,000 - divide £500 by £2,000 which equals 0.25. Multiply the result by 100 to get the percentage (in this case it’s 25%).
A lower ratio shows lenders that you aren’t reliant on credit. Raking up high levels of debt has the opposite effect. Spending over 90% of your credit limit, for example, can knock around 50 points off your credit score. Lenders are likely to see this as a red flag.
Tip: It’s a good idea to set up a direct debit. Missing just one payment could cost you around 130 points off your credit score, you may incur late fees and lose any existing promotional benefits such as interest-free offers. Don’t risk making an expensive mistake!
Paying off instalment loans
Instalment loans (like car loans or student loans) don’t contribute to your credit utilisation ratio. For this reason, paying off loans early won’t increase your credit score as much as revolving credit would.
Don’t let this put you off from clearing your loan early though if you can afford to. Paying off your loan could mean you pay less interest overall, and it could reduce your monthly outgoings. Just be aware that some lenders will apply early repayment charges to offset any interest they’ll miss out on. So you need to weigh up the pros and cons.
As mentioned above, missing payments can damage your credit score, so we suggest you set up a direct debit. Your credit score will build up gradually if you maintain your loan repayments on time, every time.
Does paying off a default improve your credit score?
Defaults apply after three to six missed payments and can lower your credit score by around 350 points. They will stay on your credit file for six years from the date of issue, before automatically dropping off. They can seriously affect your ability to get credit.
Once paid, defaulted debts are updated to ‘fully satisfied’ on your credit file. Paying them off may improve your credit score.
The impact that these markers have on your credit score lessens over time. Especially if you’ve been more responsible with money of late. Lenders tend to focus more on your recent behaviour (though lending criteria varies from company to company).
Will a partial settlement affect my credit score?
Yes, making a partial settlement may negatively affect your credit score. Paying less than the full balance could affect your ability to get credit in the future. This applies even if your lender agrees to wipe off the remainder of your balance.
Getting a partial payment offer accepted depends on your personal circumstances and the lender’s discretion.
Does debt consolidation improve my credit score?
No, debt consolidation won’t improve your credit score. You will still owe the debt and it will show on your credit file. But merging your debts onto one loan or credit card may make your finances more manageable. You’ll only have to make one monthly payment to a single lender. To get the lowest interest rates, you’ll usually need a high credit score to begin with, and fees may apply on credit cards for transferring your balance.
How long does it take for credit reference agencies to update my file?
How long it takes depends on a couple of factors:
- The lenders reporting to the agencies
- The agencies updating their systems
Experian says they refresh their data every four to six weeks when they get new information from companies. So it could take a while for a paid debt to be updated as ‘fully satisfied’ on your credit file.
What else can I do to improve my credit score?
Although your credit score won't change overnight, you can make some immediate improvements. Then it’s just a case of waiting for the other parties to do their bit.
To improve your credit score in 12 weeks follow our simple step-by-step plan, which explains things like how to:
- Register on the electoral roll
- Sign up to the Rental Exchange Initiative
- Check your report for errors
- Disassociate yourself from old financial ties
- Add your name to household bills
Paying off your debts should improve your credit score. But remember there’s no guarantee that a better credit score will lead to your credit application being accepted. This depends on your individual circumstances and the lender’s criteria.
Clearing debt may not be an immediate fix for bad credit, but it’s in your best interest to do so as quickly as possible. This will cut the cost of interest too. In the long-run, your score will improve as the impact of any negative markers decrease. Bad credit will be replaced by a better credit history if you maintain your repayments on time, every time.
Wondering whether you should close a paid credit card? Read on to find out the pros and cons, and the effect it could have on your credit score.
*£7.4 billion of debt paid in April 2020, according to the Bank of England
Disclaimer: All information and links are correct at the time of publishing.BACK TO BLOG HOME