In my last post, we discussed the reasons why you
Don’t Use Your Tax Refund To Pay Off Items On Your Credit Report!!!
If you have derogatory credit and are thinking, but I want to clean up my credit, read this first.
In that post, we discussed why you don’t use it to pay off derogatory items. Now, let’s cover why you don’t use it to pay off positively reporting loans on your credit report IF you are working on credit restoration. Remember, we are strictly dealing with credit restoration and not financial planning. From a financial planning perspective, you always want to eliminate debt and increase cash flow. Unfortunately, the rules for credit restoration for those who want to, “clean up my credit” demand a completely different strategy.
Ok, so you are fortunate enough to have some accounts in good standing that you have been paying on time, you just got your tax refund money and you want to pay them off. Sounds like a good idea, right?
From a credit restoration standpoint it is a disaster waiting to happen. Why is that? Because unless you are speaking strictly of compound interest credit cards, paying off positively reporting car loans, installment loans, mortgages, student loans, home improvement loans, etc., actually slows the process of increasing your credit score. Sounds counter-intuitive, doesn’t it?
Here’s what happens:
When you pay off installment loans early, you have robbed yourself of seasoning, payment history and number of positively reporting accounts. From a credit restoration perspective, you want installment loans open as long as humanly possible because it provides credit depth. You want to maximize the number of on time payments reported as well as the length the account was open. As I have indicated many times, if you want to, as my clients often put it, “clean up my credit”, you are going to have to buy your credit back. You do this in the form of interest payments on loans.
In many cases, you can really want to pay something off so you don’t have the mental stress of dealing with another payment or owing money. So, what is my suggestion?
Here’s a real life story from one of our clients who we just got into a dream home:
Through some very bad guidance from some incompetent mortgage loan jockeys, Brian was told to liquidate funds from his 401k to use for a down payment and place that money in a bank account so it could be seasoned for 60 days. This may not make sense, but mortgage underwriters like to see that you have had the money liquid in an account for 60 days so they can verify that it is not a quick 48 hour loan where you borrowed the money from mom and dad so the bank account would reflect a higher balance, printed the statement and then immediately withdrew the money and paid back mom and dad. So, Brian did what the loan jockeys requested, liquidated the funds and put them in a bank account where they sat waiting to hit the 60 day mark so he could close on the home he had under contract. Unfortunately, the loan jockeys neglected to tell Brian that he and his wife needed a middle credit score no less than a 620 to qualify for the FHA loan they were trying to get and neither of them had it. So, 60 days passes and Brian’s loan is declined because the score isn’t where it needs to be. It could have been with the right guidance because the middle scores were 615 and 607 and 60 days was more than enough time to get both of them over 620. In any event, Brian’s lease was up and with nowhere to go, ended up moving himself, his wife and their kids back in with Mom & Dad (never a good idea for familial harmony). Imagine if you will having $30,000 in cash in your bank account and not being able to get into a home. Sounds ridiculous, right?
Fortunately, Brian somehow found us and we quickly got him into a home 200 feet away from the home he had previously had a contract on (and our home was bigger, nicer and had a finished basement) 
While reviewing Brian’s credit report, like many clients, he told me that with the excess cash, “I want to clean up my credit” and that he had a car loan that he wanted to pay off. My ears pricked up when I heard this because anytime someone mentions paying something off while they are restoring credit, I want to make sure they understand how to do it the right way. So, I explained to Brian the information above and that ideally, though I am not an advocate of any kind of debt, he needed to keep the loan open and continue paying his monthly payments because this would give him a higher credit score for a longer period than paying it off now. I explained that I understood his psychological need to pay the car off and not go buy a nice 60″ flat screen LCD TV for his new home. And then, I told him exactly how to do it while maximizing the credit score.
Here’s what I told him to do:
“Brian, because you only have 8 months left on the car loan, your payments are primarily principal. As such, the interest expense of keeping it open for the next 8 months is nominal and worth it. So, what you want to do is determine the amount of the remaining payments and take that cash and go get a pre-paid debit card like a Wal-Mart Money Card, deposit the cash in that account with Wal-Mart and then set up the remaining car payments to draft from that account. In this way, you will have psychologically paid off the car and separated the funds from your bank account so you don’t get the itch to use the money to get the flat screen TV AND have guaranteed yourself 8 more timely payments.
And that, my friends, is how you pay off positively reporting accounts when you have the money and you are working on credit restoration.
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