When people think of debt, it usually comes with a negative connotation. Having a large amount of debt from expensive medical bills, buying a house, or overusing credit cards can feel like a huge weight on your shoulders.
Unfortunately, debt will not disappear overnight. In a lot of cases, it will take years to resolve. One step you can take towards a better financial future is to understand how debt affects your credit score. In this article, you will learn how debt impacts your credit score in several different ways. You may be surprised that debt can be a good thing in some cases!
To get a good understanding of how debt impacts your credit score, it’s important to know how your credit score is generated. Your total score is comprised of several different factors. Here are the main five that impact your score the most:
- Credit Utilization
- Payment History
- Length of Credit History
- Credit Mix
- New Credit
When you apply for a loan or credit card, it’s standard for lenders to check your credit score. When you make large life purchases like a house or car, your credit score may determine whether you’re approved or denied. Your credit score also determines your interest rate, which can be more expensive for those with average or low scores.
Needless to say, your credit score and the debt you take on affect each other. Once you’re approved for that loan and are responsible for the debt, every factor of your credit score is impacted in a positive or negative fashion. Here is a breakdown of each factor and how it is affected by debt.
1. Credit Utilization
Your credit utilization refers to the amount of credit being used out of your total available credit. The more credit that is being used up, the lower your score will be. Ideally, you want your utilization rate to be under 30 percent of your total available credit.
Technically, anything over 20 percent can raise red flags with credit score companies. Having a credit utilization higher than 20 percent can put you into the high-risk category which can, in turn, lower your score.
Credit card companies put borrowers with over 20-30 percent revolving credit utilization at a higher risk of maxing out their credit cards, which could lead to a situation where your balance can eventually exceed your available credit line. This is the worst-case scenario for your credit score.
With that in mind, it is extremely important to pay off revolving debt as quickly as possible and try to keep it under 30 percent with under 20 percent being optimal.
Having large amounts of debt has a negative impact on this factor or your credit score. The only way you can improve in this area is to work on paying off your debt.
2. Payment History
Payment history carries the most weight when it comes to your credit score. Making payments on time accounts for 35 percent of your FICO score. Compared to the other factors of your score, this is the most significant. While it is ok to miss a few payments over time, anything more than that can significantly lower your score.
When you take on any form of debt, there will be a repayment plan set in place. Each month, you will have to make a payment on the account before the due date. If you do not make a payment on time, it will be reported to the credit bureaus as a missed or late payment, resulting in a hit to your credit score.
When considering late payments, credit score companies look at how late the payments were, how much is owed, the recency of the occurrence, and the number of late payments that have been recorded. With that in mind, it cannot be stressed enough how important it is to pay all your accounts on time.
Having a debt that you’re in the process of paying can either improve or harm this factor of your credit score. It’s entirely in your hands to be responsible for on-time payments. If you pay on time, your score will gradually see a rise. If you’re late or miss a payment altogether, it will have the opposite effect.
3. Length of Credit History
The length of your credit history accounts for 15 percent of your FICO score. When you have had a line of credit open for a long period of time, this demonstrates to lenders that you can manage long-term accounts responsibly.
In this aspect, debt can have positive effects on your score. Whether it be a credit card, mortgage, or auto loan, if you consistently make on-time payments for long periods of time, your score will see a gradual increase.
What that being said, don’t be too quick to close any accounts that you’re not using. When dealing with debt, it may be tempting to close all of your accounts and start over. This will prove to harm your credit score more than it would if you paid your debts and kept the accounts open.
4. Credit Mix
Credit mix refers to multiple types of credit being utilized. This can include credit cards, auto loans, mortgages, and other accounts. Having a variety of different types of loans accounts for 10 percent of your FICO score.
With that in mind, it is undeniably important to have a good mix of credit. Having a mortgage, car loan, and credit card balance that you’re making on-time monthly payments on is vital to establishing a good credit score.
In this case, the type of debt you have is important. If you only have a credit card, this factor of your score will be negatively affected since there is a lack of diversity. If you have a credit card and are making payments on a mortgage, you may see small improvements to your score due to having a stronger credit mix.
5. New Credit
The final main factor that determines your credit score is your history of opening new credit accounts. Opening multiple new credit accounts in a short period can raise some red flags.
When you open up a lot of accounts quickly, this is considered to be viewed as a high-risk action by lenders and can cause your score to take a hit. This is especially relevant to those who do not have a long credit history.
It’s important to remember that credit cards are a form of debt. They are helpful in many ways but can be harmful to your financial wellbeing if mismanaged. Try to be mindful of not opening too many accounts too quickly if you don’t already have a strong history of borrowing.
Having gone over the different factors that determine your credit score, it is clear that there are many different steps you can take to improve your credit. With those factors in mind, here are five tips to help you improve your score:
Tip #1: Always pay your bills on time.
Payment history carries the most weight when it comes to your credit score. With 35 percent of your FICO score attributed to making payments consistently on time, it is essential not to miss payments and always pay them on the due date.
Tip #2: Monitor your credit utilization.
Try keeping overall credit use to under 30 percent of your available credit limit. This ensures that you will not be considered a high-risk borrower by the credit score companies. If your credit utilization ratio is high, create a repayment plan that is reasonable and stick to it.
Tip #3: Be mindful of the number of new cards you’re applying to.
Too many inquiries for new credit cards will be noted by credit score companies, and will ultimately lower your ability to borrow money at reasonable interest rates.
Tip #4: Keep a good credit mix.
It is also crucial to keep a mix of different types of lending accounts. Credit mix in use is a significant portion of your overall credit score and can help you maintain good standing with the credit agencies.
You should never take on more debt than you can handle, but if you’re looking to optimize your credit score, it helps to have a variety of debt.
Tip #5: Eliminate debt collection accounts.
If applicable, be sure to close down any debt collection accounts by paying them off directly or through a debt settlement offer. While not mentioned as much in this article, it’s still extremely helpful to get accounts in collections taken care of.
Debt can have a tremendous impact on your well-being and the happiness of those around you. With the discipline and willingness to adhere to the standards that credit agencies expect, having great credit doesn’t have to be as difficult as it seems.
By paying bills on time, keeping track of your credit utilization, not applying for too many cards, and having a good mix of different types of credit, you will be on your way to improving your credit in no time.
Having a high credit score gives you the freedom to make major purchases without having to stress out about high down payments and high interest rates.
By taking note of the different factors that determine your credit score, you can have a better understanding of how to move forward in your credit journey.
While taking these steps can seem difficult or tedious, it is essential to remain on top of these things to ensure a better financial future for yourself and your family. If your credit is not where you want it to be at the moment, try not to worry too much. Bad credit is easily correctible if you put in the work to make it better.
We often don’t realize how easy it is to let debt spiral out of control. If you pay attention to the things credit agencies pay attention to, you can understand how your debt impacts your credit score and ways to improve it.
Having a high credit score doesn’t have to be impossible. Just follow the steps outlined in this article, and you will be surprised at how high your score can get by being patient and consistent.