The average person cannot live without debt. Whether it’s buying a home, financing a car, paying for college or building a credit score, we all need debt to reach our goals. As a vital part of life, it’s important to know the basics of debt and its impact on your credit score. Read on to learn more.
Are there different types of debt?
Yes. Debt is usually divided into two categories:
- Installment: A loan with a fixed interest rate that is paid back in equal parts over a determined period of time. Examples include 30-year mortgages, auto financing, personal loans, etc.
- Revolving: Debt with a variable interest rate and an open-ended payoff date. Credit cards and some private student loans are common forms of revolving debt.
How does debt affect my credit score?
Debt accounts for 30 percent of the FICO scoring model, representing a significant chunk of your credit score. The effect on your credit score can be positive or negative depending on personal habits and vigilance.
Potential positives include:
- Experience. Creditworthiness is based on experience, and lenders like to see a long and stable credit history. For example, a mortgage loan can boost a stagnant credit report by providing an installment account with fixed, affordable payments.
- Diversity. Maintaining a healthy mix of installment and revolving debt is the best way to build a solid credit report. Bonus: Diversity is also one of the five factors of credit scoring.
- Opportunity. Debt can yield profitable opportunities with the correct approach. For example, suppose you apply for a $100,000 to buy a home with significant damage. You spend a year remodeling the property and sell it for $425,000. What was once a simple debt has become an opportunity to invest further, reduce other debts and save for retirement.
Potential negatives include:
- An inflated utilization ratio. High debts can lead to credit damage in the form of utilization. For example, Mary currently has an $8,500 balance on a credit card with a $10,000 limit. Thanks to a utilization ratio of 85 percent (amount owed/total credit limit), Mary’s credit score takes a noticeable dip.
- High interest rates. As we learned, too much debt can lead to credit score damage, a catalyst of high interest rates. In Mary’s case, her credit card interest rate rises from 18 percent to 20.2 percent in response to her account balance and a single missed payment. This shift makes it more difficult for Mary to pay off her debt, a consequence that could lead to further credit damage.
- Risk. Nearly half of Americans don’t have enough savings to cover the cost of their consumer debt. Relying too heavily on borrowed cash is an easy way to land in financial trouble.
Can I have too much debt?
Absolutely! Overspending is a common culprit of credit damage. Limit yourself wisely by:
- Reducing installment debt to 43 percent or less of your gross annual income. For example, if you earn $4,000 per month, your installment debt should never exceed $1,720.
- Reducing revolving debt to 25 percent or less of your total credit limit. This is also known as your credit utilization ratio. For instance, if you have three credit cards, each with a $10,000 limit, your combined debt should never exceed $7,500, or $2,500 per card.
What are the rules of debt management?
Debt management can be complicated, but there are a few basic rules, including:
- Budgeting. A solid budget can mean the difference between success and disaster. Use our template to create your own.
- Auditing. There’s always room for self-improvement. Audit your expenses as you begin budgeting and look for ways to cut back. Reducing unnecessary debt will boost your credit score and take the burden off your bank account.
- Education. Are you worried about the credit repair process? Don’t be! Our blog is filled with resources designed to provide consumers with knowledge and confidence. Our services are also designed to suit every budget and address the financial problems you face.
The bottom line: Debt can be a tool or a liability, and the choice is yours. Stick to the rules and practice smart spending.