Q: My wife and I just received $20,000 that was left to me from my grandfather. We put the majority toward paying off our home but would like to pay off our credit cards.
Would paying them off totally help our credit score more than just paying them down a little? How should we proceed?
A: How you manage the different types of credit that you own, and the length of time you have owned these pieces of credit, are a big part of your credit score. But another important part is the ratio between the debt you carry and your available credit.
For example, if each credit card has $10,000 of available credit, and you carry $8,000 on each card, that’s 80 percent of the available credit of that card. Using more than 20 to 25 percent of your available credit will lower your credit score.
The lower your debt-to-available credit ratio, the better it is for your credit history and credit score.
With that in mind, your smartest move is to pay off your credit card debt entirely. But there’s another reason to pay off your credit card debt: It’s non-deductible debt.
By that I mean you can, if you itemize on your federal income tax return, deduct the interest you pay on your mortgage and home equity loan (if you have them). That has the net effect of lowering the interest rate on the loan. But the interest you pay on credit card debt is not deductible. So you pay whatever is the stated interest rate.
Also, paying off your credit card debt is usually better than paying off part of a mortgage. Generally, interest rates on credit card debts are far higher than interest on a home loan. Today’s credit card interest rates can approach 30 percent and most home loans, even high interest home loans, are below 10 percent.
In the long-run, the savviest way to manage paying off your debt is to pay off your highest non-deductible debt first, such as your credit card debt. Then, tackle your car loan(s). Then, school debt and finally your mortgage.