Debt is a dirty word, for millions of Americans, and yet, the average household depends on it for survival. Despite the negative connotations, did you know that owning a mortgage, auto loan and/or student loan can actually help your credit? Surprising, but true. Long-term debts have the ability to improve your credit scores by creating:
- Payment history. When it comes to the factors that determine your credit score, payment history is at the top of the list. Credit bureau scoring models value consumers who pay their bills on time—and for extended periods of time. Payment history also accounts for collections, charge-offs and bankruptcies caused by overdue bills. Carefully managed long-term debts illustrate your ability to pay on time and in full, two qualities you’ll need for credit health and future loan approval.
- Credit length. Long-term debt is all about length, another primary factor in credit scoring. 15 percent of your credit hinges on the length of activity listed on your credit reports. Gaining positive experience recommends you to future lenders and helps improve your score. Seven years or more is the ideal credit length, and you’ll need long-term accounts to help your score remain positive and active.
- Tax breaks. An overlooked benefit of long-term debt is the tax breaks many enjoy. For example, the interest paid on your mortgage and student loans can be written off by Uncle Sam on April 15. This perk allows you more money to focus on debt reduction, saving for your kids’ college expenses and planning for retirement.
- Equity. The primary benefit of ownership is equity, and the average family needs the initial long-term debt to secure it. While your income can’t support a cash payment for a new car or home, an auto loan or mortgage allows you to “own” property with interest attached until it is paid off entirely. The amount of interest you pay is based on your credit rating, and will determine the sum of equity once your debt is repaid. For example:
Sam buys a home for $400,000 at 6 percent interest. His loan is paid in 30 years for a grand total of $863,353.
Suppose Sam improves his credit and buys the same home at 4 percent interest. His loan is paid in 30 years for a grand total of $687,478.
Total savings/equity: $175,875
It’s easy to see the relationship between borrowing, earning, and credit health: the success of one depends on the others.
- Earning potential. Ownership, equity and education all carry the hope of a single goal: earning potential. For example, suppose you bought a home in Chicago shortly after the housing crash of 2008. You paid $154,000 for a two-bedroom condo on the North side with new finishes and gated parking. Eight years later, the market has improved, the neighborhood is revitalized and your earning potential is soaring. Realtors estimate your home’s current value at $325,000, allowing you to sell for tidy profit and reinvest in a larger home.Similar to buying a home, federal student loans allow you to invest in education to achieve career opportunities and a better salary throughout your life. While the initial debt may hurt, its effects can change your life for the better.
The bottom line: Debt management is all about perspective: while some view it as a burden, others view it as a tool for success. Adopt a positive mindset and learn more about how debt can improve your credit rating. Knowledge is essential.