The Complete Guide on How Debt Impacts Your Credit Score
The average indebted household that doesn’t pay credit cards in full each month carries $8,683 in credit card debt. Eventually, that debt affects the card members’ credit scores.
A credit score impacts the ability to borrow money, leading to higher interest rates, bigger down payment requirements and possibly longer loan terms to make the higher payments affordable.
Low credit scores can also affect insurance rates, car and home loans, the ability to get a job and rent an apartment.
By cutting back on debt, consumers can improve their credit scores and make their financial lives a lot easier.
Ways Debt Can Impact Your Credit Score
Here are some of the biggest ways debt impacts credit scores:
Credit Utilization Ratio
Your credit utilization rate, also called a credit utilization ratio, is how much of your available credit you’re using when your credit score is calculated. The more credit you’re using, the more it can drop your credit score.
Figuring out the ratio is simple math. Divide an account’s outstanding balance by its credit limit and you’ve got the credit utilization rate.
For example, the equation on a $10,000 balance on a credit card with a $20,000 limit is $10,000 divided by $20,000 to equal 0.50, or a credit utilization rate of 50 percent.
That’s high, and a rule of thumb is to keep it below 30 percent to help improve a credit score. Keeping a credit card balance low by paying off the debt will keep the credit utilization rate low.
If it’s higher than 20 percent, credit score companies consider it an indicator of future repayment risk and that you’re close to maxing out your credit cards. Having a credit card balance that’s over the card’s limit is the worst way to affect credit utilization.
The higher the utilization rate, the greater the risk is that you’ll default on a credit account within the next two years, according to FICO, one of the major credit scores used by credit reporting agencies.
This is part of the “amounts owed” part of a credit score, making up 30 percent of a credit score.
Along with the ratio, there’s the total amount of credit utilization to worry about. This is the total credit balance from all of your credit card balances add up together. A low balance shouldn’t affect this, and could have a more positive impact on a credit score than not using any of your available credit at all.
Credit Payment History
How you pay your credit card debt is the most important part of a credit score, with payment history accounting for 35 percent of a FICO score. In other words, paying your credit payments on time.
A few late payments are OK, but more than twice can hurt a score — and on more than just credit cards.
Credit payment history can include retail accounts such as department store credit cards, installment loans such as car loans, finance company accounts, and mortgages.
Credit scoring companies may consider how late the payments were, amount owed, how recently they occurred, and how many late payments you have. Having a good track record on paying most of your credit accounts on time will increase your credit scores.
Along with getting information from creditors on late payments, credit scoring agencies will also consider bankruptcies that will remain on credit reports for seven to 10 years, lawsuits and wage attachments.
Length of Credit History
Having debt can seem like it does nothing but hurt a credit score. But it can help it too. A longer credit history will increase credit scores, even for people who haven’t been using credit too long.
Depending on the rest of their credit report, a longer credit history will generally affect 15 percent of a credit score. This includes how long specific credit accounts have been established and how long it has been since you used certain accounts.
Credit Mix in Use
As mentioned above in credit payment history, the types of credit you have can affect a credit score. So can having a mix of types of credit, which accounts for 10 percent of a credit score.
This mix includes credit cards, retail accounts, installment loans, finance company accounts and mortgage loans. Varied types of credit show you can handle different types of loans, provided you pay them on time.
You don’t have to have each of the above debt types, but a mix will help a credit score. And don’t open accounts just to have them and add to your mix. Only open credit accounts you need and will use.
Opening several credit accounts in a short period of time is considered a big risk by lenders, and thus credit scoring agencies, and can hurt a credit score. This is especially true for people who don’t have a long credit history.
New credit determines 10 percent of a FICO score. It considers how many new accounts you have by type of account.
New accounts will lower your average account age, such as the length of credit history, as detailed above. If you don’t have a lot of other credit information, opening a lot of new accounts at once can have a larger impact on your credit score. Even for people with a long credit history, opening a new account can lower a credit score.
If you’re working with a debt consolidation company to help manage your debt and pay it off, your credit score could drop because it’s considered opening a new account. A new account will also affect your average credit age.
How To Shop For New Credit
If you’re shopping around for credit but aren’t opening new accounts, then it shouldn’t affect your credit score too much, if at all — less than five points off a credit score for one credit inquiry.
Inquiries are where a lender makes a request for your credit report or score. Inquiries can have a greater impact if you have few accounts or a short credit history. People with six or more inquiries on their credit reports can be up to eight times more likely to declare bankruptcy, according to FICO.
Inquiries remain on a credit report for two years, though FICO scores only consider them for the past 12 months. Many types of inquiries are ignored completely and “rate shopping” is allowed in determining a credit score.
Suppose you apply for several new credit cards in a short period of time. These inquiries will appear on your report and can be seen as the applicant being a higher risk.
However, multiple inquiries from auto, student loans or mortgage lenders in a short period are allowed and won’t affect most credit scores. These inquiries within 30 days of each other are usually treated as a single inquiry and will have little impact on a credit score.
If you’re shopping for a home, auto or student loan and find a loan within 45 days, the inquiries won’t affect your credit scores. Some scoring formulas drop that to 30 days.
Improving Your Credit
There are many ways to improve a credit score, but the main ones are:
- Pay bills on time.
- Keep credit card balances low, under 20 percent is best.
- Apply for and open new credit accounts only as needed.
- Keep a mix of debt accounts.
- Get rid of all debt collections accounts either by paying them off directly or a debt settlement offer.
Your debt directly affects your credit score. Managing it responsibly through the ways listed above should help you improve your score and ultimately make credit work to your advantage with better credit terms.
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