Should I Pay Off My Loans or My Collection Accounts First?

© 2009, Brandon Cornett. All rights reserved.

Reader Question: I have several outstanding accounts that are in collections somewhere. I don't even know which company owns them anymore. I have enough money to pay off at least two loans. Which should I do first, pay off accounts in collections or the loans?

We cannot offer that kind of specific advice. But I'd be happy to help you reason things out.

It really depends on what your immediate goals are. If you're simply trying to improve your credit score, then paying your old collection debts might be a good place to start. Of course, a negative entry from a collection agency can only stay on your credit report for up to seven years. They can try to collect on it forever, if they want to, but it can only remain on your report for seven years maximum.

Here's what the folks at MyFICO (creators of the FICO scoring model) have to say about this subject: "At myFICO we always recommend paying off your legitimate debts, and paying off old collections won't hurt your FICO score." -And if they're not experts on their own scoring system, I don't know who is!

Also, keep in mind that paying an old collection item doesn't necessarily mean it will be scrubbed from your credit report entirely. The status of those accounts will be updated to reflect the payment, but the items themselves may remain on your report until the seven-year point. However (and this is a big "however"), settling an old debt can go a long way in the eyes of a mortgage lender. Walking away from your old debts, on the other hand, sends a very bad signal. So consider this if you're planning to apply for a mortgage in the near future.

Your other loans will either have a positive or negative impact on your credit score. If you make your payments on time, the effect will be positive. If you routinely miss your payments (and those defaults are reported to the credit bureaus), it will have a negative impact on your score. So if you're currently keeping up with the payments on the other loans, there's really no reason to pay them off right away -- unless you really want to. It will certainly help your debt-to-income ratio by paying the loans off. But in terms of your credit score, it's the payment history that matters most.

This is more than just a credit question. This is a general budget question, and also a quality-of-life issue. But hopefully I've at least given you some food for thought. Good luck.

Related Q&A sessions:

• Will paying off my bills raise my credit score?
• Should I pay off my unsecured loan to improve my score?