A decent amount of people maintain a balance on their credit cards, home equity line of credit, or various other lines of credit. The common rationale behind maintaining a balance rather than paying it off is because they believe it will help their credit score, or they don’t want their line of credit to be closed. While it may seem like this is the case, it is usually very advantageous to pay off these credit lines in full each month.
The most obvious benefit to paying down on debt is saving on future interest payments. Depending on what type of debt you have, this can range from saving just a couple of percent, to saving large chunks of money each month. For example, most credit cards charge somewhere around 20% interest annually. If you pay down $1,000 of credit card debt then you have immediately saved yourself about $200 for the year in interest. If you have a more reasonable interest rate, for example on a home equity line of credit, then you may only be saving 4% for the year. Even still, paying $1,000 down results in $40 saved which would have been spent on interest payments. Interest which would have resulted in you being no closer to achieving your financial goals.
These examples don’t account for interest saved on future interest accrued. Back to the credit card example above, you would save $200 for the year if you paid an extra $1,000 towards your debt. However, you will also save $200 for every year from now on due to interest never accruing again on the $1,000 principal. On top of this, you will not have to pay additional interest as a result of the interest accrued on your principal. In this example, in year 2 you would have needed to pay an additional $40 in interest because the credit card company would have charged 20% on the $200 of interest that accrued. If you continue down this rabbit hole, it is easy to see why paying off debt, especially high interest rate debt, can go a long way towards helping you save for your financial goals.
How it Impacts Your Credit
We occasionally discuss paying down debt with people who have avoided it for a long time for various reasons. While most of the time the reason is due to cash flow not being able to support extra payments, there are other reasons we have heard. These alternative reasons include believing making an extra payment will hurt your credit score, and thinking the credit line will be closed if you don’t carry a balance.
Making extra payments to pay down debt is actually better for your credit! Two of the major components in calculating credit score are number of missed payments and credit line usage. If you make an extra payment, then your total credit line usage will decrease (which the credit rating companies like), and it will also prevent you from having more missed payments which is another bonus! Additionally, the credit company will not close your line of credit because you have 0 balance. The main reason they would close the credit line would be if there is no activity for an extended period of time. However, if you are using the credit line and simply paying it off every time the payment comes due, they will not close your account.
Credit can be a very useful tool on your financial journey. Whether it is used to buy a house, buy a car, or simply to shore up day to day expenses, it can provide a benefit to your life. However, abusing credit can become very detrimental. Because of the large interest rates, and the math behind compound interest, it is very beneficial to pay down debt if cash flow allows you to. If you would like to speak with a financial planner who can help analyze your debt situation and come up with a repayment plan please give our office a call at (734) 681-7575 or email me at email@example.com.