Discharging debts certainly ameliorates your credit score, but it is not true in all circumstances. Your credit history is not the only quintessential element to have a loan application approbated. Sometimes, the reason for a decline to your application is your affordability, not your credit score.
Three credit reference agencies maintain your credit record, and each of them consists of different information and uses various methods to calculate your credit score. Despite that, it rarely happens that you are a responsible borrower according to one bureau and a subprime borrower according to the other.
It is no wonder that people see no credit score improvement despite paying off their debts. Well, there are so many reasons why it does not help ameliorate your credit rating.
1. Discharging your debts and shuffling are two different things
A credit score is an acknowledgement of responsible payments. If your credit history is excellent, it clearly insinuates that you paid off your dues on time. If your credit report is not up to scratch, it suggests that you missed payments and made defaults in the past. Some people shuffle debts and assume they have been paying them off.
Discharging a debt means you are clearing your dues from your income and savings, so you owe less money overall. But if you are taking out bad credit loans with no guarantor and applying for credit cards to pay off your dues, you are shuffling, not paying it off.
Debt shuffling is helpful to reduce interest rates. For instance, when you consolidate your outstanding debts with a new loan, this cannot lower the total amount of money you owe.
Your affordability also depends on how much you already owe. If you have already taken on too much debt, your lender will be indisposed to approve your application. If somehow any lender signs off on it, it will be an exiguous sum and charge high interest rates.
2. Your credit utilisation ratio is extremely high
Your credit utilisation ratio will affect your credit score too. This ratio suggests how much you owe against your credit card balance. An ideal ratio is 30%, and if it goes beyond, your lender will start being sceptical about your repayment capacity. If it is too high, your application will be repudiated straightaway. You will see a significant drop in your credit score if you have exhausted more than 90% of your credit card balance. On the other hand, you will get a boost when it is below 30%.
Many people are under the impression that their credit history will not be affected due to a high credit utilisation ratio as long as they have been paying off their credit card debt on time. If you take out a new loan with a high credit utilisation ratio, your affordability and credibility will be called into question. Of course, it would be hard for you to deal with another debt along with credit card payments.
If a lender manages to give the nod to your application, they might charge slightly higher interest rates because of the risk of default. Likewise, if you try to apply for a 0% credit card, you will most likely be turned down.
If you are already facing rejections due to a high credit utilisation ratio, you should try to reduce your credit card usage. This will undoubtedly help you improve your credit score. Once you have maintained a consistent credit utilisation ratio, which is not more than 30%, you can qualify for a 0% balance transfer card too.
It is worth remembering that credit card maxing can easily lead to credit card debt in unexpected scenarios, such as a job loss. Once you have fallen behind on your credit card payments, you will have to discharge it in fell one swoop. If you cannot, interest will keep accruing. As a result, your credit score will significantly drop, and then you will be eligible only for loans for people with a very bad credit rating. Unfortunately, these loans carry very high interest rates.
3. No credit score improvement if you are paying off defaulted debts
Some people sign up for payment arrangements to settle their dues. Such methods to discharge your debt cannot help you improve your credit score. This is because you have already made a default. If you had to opt for payment arrangements, it clearly showed that you were absolutely reckless with the debt you took on.
You should always try to take control of your finances before you hit rock bottom. If your income is not so strong, you should figure out some ways to make some money. Identify what is pushing you over the edge of debt. It might be excessive credit card usage. Having identified the cause, you should fix it. For instance, you can stop relying on credit cards to make all purchases.
4. Defaults on your credit report are also a snag
When you miss a payment, you will undoubtedly be charged late payment fees and interest penalties, but you have a chance to stall lenders from reporting it to credit reference agencies if you clear the payment within 30 days. A default happens when you continue to miss payments. If you miss payments for three months in a row, your account will go into default. Once it is recorded on your credit file, you will see a significant drop in your credit rating.
Unfortunately, defaults continue to appear on your credit file for more than six years. It means your credit score will continue to be bad until defaults and missed payments are removed from your credit file.
It is crucial to note that:
- The settlement of defaulted debt will never increase your credit score.
- Once you have discharged all your debts, few lenders would be willing to approve your application.
- On no account will any lender approve your application for a long-term loan immediately after the settlement of defaulted debts.
- Your credit score will continue to be bad even after defaulted debts are removed from your credit file unless you start making some efforts to improve it.
- If managing payments is difficult, you can choose a smaller repayment plan. It cannot do up your credit rating, but it can preclude you from having a CCJ.
In order to fix your credit after discharging defaulted debts, you should:
- Take a break from borrowing money for at least a year.
- Take out a credit builder loan. These loans will help improve your credit score because payments are reported to credit reference agencies.
- Make sure that you do not max out your credit card. Use it for small purchases and pay them off on time.
The final word
It is vital to pay off your debts to improve your credit score, but there are specific scenarios when it is not possible. For instance, when you are taking out a new loan to discharge your existing accounts, you will not see any reduction in the debt size, and hence no credit score improvement.
You should take on debt cautiously. Only if you are sure about your repayment capacity should you borrow money.