Your credit scores have a ripple effect on many areas of your financial life, which is why it’s important to understand the best strategies for keeping them in good standing.
Debt, like many things in life, serves you best when used in moderation. Not paying off your balances regularly can hinder your financial standing. Here’s the breakdown of how debt impacts your credit scores in positive and negative ways.
What Things Affect Your Credit Score?
The higher your credit scores, the better financial opportunities you’ll have when it comes to loan approvals, lending options, interest rates and payment terms.
Your credit scores are shaped by several factors, and each one contributes like this:
- Payment History (40%): accounts for how often payments were missed or late
- Amount of Debt (35%): looks at how much you owe, as well as how much you owe when compared to how much available credit you have
- Credit Age (10%): considers how long you’ve had established credit in good standing
- Credit Mix (10%): refers to the types of accounts in your name i.e. revolving credit, installment loans, etc.
- New Activity (5%): is when a lender pulls your credit file to access your risk level when you apply for a loan or credit, triggering a hard inquiry.
Because there’s a delicate balance between owing too much and too little, understanding how debt impacts your credit score will help you make smart decisions about taking on a new credit card or loan.
Why Debt Matters: Credit Utilization
The amount of your current debt tells a potential creditor or lender whether or not you can afford to take on more. This is why your credit utilization ratio is important. Credit utilization refers to the percentage of available revolving credit you’re using in relation to your credit limit. Revolving accounts include credit cards, retail cards, personal lines of credit and home equity lines of credit (HELOCs).
Creditors prefer a credit utilization of 30% or lower, and the lower the percentage, the higher your scores may be. So if your credit limit is $1,000, the sweet spot is keeping your balance below $300.
However, having no credit utilization, meaning no revolving debt at all, can actually drop your scores. This is because creditors like to see that you can take on debt — and pay it off on time, every time.
While credit utilization compares the amount of your debt to your credit limit, debt-to-income looks at how much you owe compared to how much you make. The debt-to-income ratio is determined by what percentage of that income you pay toward debt every month.
A high debt-to-income ratio won’t impact your credit scores; however, it can be particularly challenging when applying for a mortgage. If a significant portion of your income goes to paying off your existing debt every month, a lender may assume you can’t handle any more debt. Or if you’re approved for the loan, it may be only with a higher interest rate to offset the lender’s risk.
Paying Off Debt
If you take on debt, it’s your responsibility to pay it off. Even one missed or late credit card or loan payment will negatively impact your credit scores.
While it’s important to make all your debt payments on time, you’ll save the most money by paying off the balances with the highest interest rates first, which usually applies to credit cards. Take note: Even when a card is paid off, keep the account open as credit age also impacts your scores –and older is better!
Being responsible with your debt is essential. Use debt wisely, and set your credit profile up for success.