How Debt Affects Your Credit Score
As you've probably already figured out, debt plays a big part in your financial life. Not only does it affect your spending ability, it also has a direct impact on your credit score and a direct impact on your ability to borrow money or pay a low insurance rate.
The amount of debt you have is one of the biggest factors that goes into your credit score; your level of debt is 30% of your credit score. The credit scoring calculation considers your credit utilization – the ratio between your credit card balance and your credit limit – for each of your credit cards and your overall credit utilization. The higher your credit card balances are relative to your credit limit, the more it hurts your credit score. Maxed-out and over-the-limit card balances are the worst of all.
Your credit score also takes into account how close your loan balance is to the original loan amount. Paying your loan balances is better for your credit score.
Carrying a lot of debt, especially high credit card debt hurts your credit score and your ability to get approved for new credit cards and loans. Even if your debt-to-income ratio is low, if your debt hurts your credit score, you could still be denied. (Note that your income isn't a factor in your credit score.)
Handling Your Debt
How you handle debt also has an impact on your credit score. Paying off your balances quickly helps raise your credit score because you’re lowering your credit utilization. If your debt is too much to handle, your credit score could suffer. For example, if you miss payments because you can’t afford your debt, you’ll lose credit score points.
Choosing debt settlement or bankruptcy to deal with your debt will result in credit score damage that takes several months, even years, to recover from. Credit counseling and debt consolidation don’t directly affect your credit score. But, debt consolidation can have a negative impact on your credit score. You could be penalized for opening up a new account, an action that lowers your average credit age. Age of credit is 15% of your credit score. (While some debt solutions can hurt your credit score, they may still be worth considering.
You can rebuild your credit score over time, and being debt-free is still good for your overall financial health.)
One of the myths about building a credit score is that you have to carry a credit card balance to boost your credit score. That’s not true. As you read above, carrying a credit card balance that’s too high actually hurts your credit score. You can use a credit card, pay off the balance in full each month, and build a good credit score without getting into debt.
Ten percent of your credit score considers the types of accounts you have. Having experience with various types of accounts – credit cards and loans – helps increase your credit score. So, if you’ve never had a mortgage, your credit score could go up if a mortgage is added to your credit report. But, it’s never a good idea to take out loans just to boost your credit score. It could backfire. Let your credit score build naturally by borrowing only the money you need.