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This chapter is from the book

Step 3: Pay Down Your Debt

Remember that the second most heavily weighted factor in credit scoring is how much of your available credit you're actually using. The lower your balances compared to your credit limits, the better.

The score gauges how much of your limit you use on each card or other revolving line of credit, as well as how much of your combined credit limits you're using on all your cards. The score also factors in any progress you're making on paying down installment accounts such as auto loans and mortgages.

Paying down your debt over time is a way to show consistent, responsible credit-handling behavior and will boost your score.

What does that mean in practice? Read on.

You Need to Reduce What You Owe, Rather Than Just Moving Your Balances Around

With credit card companies battling each other fiercely for customers and 0 percent balance transfer offers now commonplace, it has become quite a sport for some people to bounce their balances from one low-rate credit card to the next. These folks often are quite proud of the "savings" they think they're getting from taking advantage of such teaser rates.

Unfortunately, this strategy is fraught with peril. For one thing, opening new accounts can ding credit scores. So can transferring a balance from a high-limit card to a lower-limit card. (Remember: The more of your credit limit you use on any given card, the bigger the hit on your credit score.)

If you continue to charge on your cards instead of paying down your balances, you're using more and more of your available credit limit—and doing more and more damage to your score.

The way to improve your score is to stop the merry-go-round and start actually making a dent in your debt. To do that, continue reading.

You Might Need to Change Your Approach to Paying Off Debt

The usual advice to debt-ridden consumers is that they should pay off their highest-rate debts first, and use lump sums to retire any bills they can afford to pay off in full. That makes a lot of financial sense, but unfortunately isn't the fastest way to improve your credit score. Instead, you should do this:

  • Prioritize your debts by how close the balances are to the accounts' credit limits—If boosting your score is your goal, you should look for the card or other revolving account that's closest to its limit. After that's paid down below 30 percent or so, you can switch to the card or other account that's the second closest to its limit. Your goal should be to eventually pay off all this debt, continuing in this round-robin fashion.

  • Avoid consolidating your debts—Many people want to transfer their balances to a single card, either to take advantage of a low rate or for the convenience of having only one due date and interest rate to worry about. But for credit scoring purposes, it's better to have small balances on a number of cards than a large balance on one card or other revolving line of credit. That's because the score looks at the gap between the balance and the limit on each card, as well as on all your cards put together.

If you've already consolidated, though, you should probably just stay put. Applying for new credit or transferring balances, as noted earlier, can hurt your score and offset any gain you might get.

If you think all this doesn't apply to you because you never carry a balance, think again.

You Need to Pay Attention to How Much You Charge—Even If You Pay Your Balances Off in Full Every Month

As noted in the previous chapter, the credit bureaus—and thus your credit scores—don't differentiate between the balances you pay off and those you carry from month to month. The balances that are reported to the bureaus are typically the ones that show up on the monthly statements you're sent. Even if you pay off your bill in full the day your statement arrives, you will likely still have balances showing on your credit report, and those will be factored into your score.

Now, paying your balances in full every month is an excellent financial habit. If you're not doing it already, that should be your goal. Not carrying a balance can save you hundreds, if not thousands, of dollars a year in interest payments. Besides, carrying a balance leaves you vulnerable to all kinds of nasty creditor tricks, like jacking up your interest rates with little warning—something that's increasingly common as credit card issuers try to boost their profits.

But even if you can and do pay your balances off, you need to pay attention to how much you're charging each month. You need to stay below—well below—your credit limits.

You know by now that you shouldn't max out your cards or come anywhere close to your credit limits. But the amount of your credit limit you should be using might surprise you.

Your balances (the amount you carry plus the amount you charge) shouldn't exceed 30 percent of your total credit limit at any given time. The higher your score, the lower the percentage of your credit limits you would need to use to improve your numbers. If your score is already in the high 700s or 800s, you might need to use 10 percent or less of your limit to boost your score.

How to Find Money to Pay Down Your Debt

Paying down debt is a lot like losing weight—easier said than done. But most people can find ways to trim their expenses, boost their incomes, and free up more money to pay off their debts. Here are just a few examples. You can find lots more on Web sites devoted to frugality, such as The Dollar Stretcher at http://www.stretcher.com, or in books such as Amy Dacyczyn's The Tightwad Gazette.

  • You can sell stuff—Hold a yard sale, take clothes to consignment shops, sell unneeded vehicles, and auction off unneeded items on eBay. The money generated might go a long way toward paying off your debts.

  • You can trim your spending—The easiest ways to save are to eat out less often, shop using a grocery list, and entertain yourself at home rather than going out, but you probably can find several other places in your budget to trim. Personal finance software, such as Quicken or Money, can help you track your spending, but you also can try just writing down every penny you spend for a couple of weeks. You're bound to find little ways that money leaks out of your wallet. Stop those holes, and you can redirect the savings toward debt.

  • You can moonlight—Few people would want to hold two jobs for long, but you might be able to handle it for several months or however long it takes to put a dent in your debt.

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