Your debt and credit score are inextricably intertwined. After your payment history, the amount of debt you have is the most important factor in your credit score. Here are some ways that debt affects your credit score:
Credit Utilization
Your payment history accounts for about 35% of your credit score, and your credit utilization accounts for about 30% of your credit score. Your credit utilization is basically a measure of how much of your available credit you are using. It’s usually expressed as a percentage. If you have two credit cards with a total of $5,000 in available credit, and you have $4,000 in credit card debt, you are using 80% of your available credit.
This is not a good thing. When you are close to maxing out your credit cards, your credit score range is negatively impacted. The algorithm used to determine your credit score heavily weights the amount of debt you have in relation to how much credit you have available. If you can get your credit utilization down to 50%, you will see an improvement in your credit score. Get it to 30% or below, and you will do even better.
Your credit utilization is one of the reasons that you need to be careful about canceling a credit card when you pay off your debt. If you have a $3,000 limit on one card, and a $2,000 limit on another (total of $5,000), you can damage your credit score by canceling a card. Yes, you want to get out of credit card debt. Let’s say you pay down your $2,000 card, but you still owe $2,500 on your $3,000 card. If you keep both credit card accounts open, your credit utilization is 50% (2,500/5,000). However, if you cancel the $2,000 card in celebration, your credit utilization immediately changes. Now, it’s 83.3%. Canceling that credit card, instead of helping your score, has actually hurt it.
Types of Debt
To a lesser extent, the types of debt you have also affect your credit score. The types of debt you have account for about 10% of your FICO score. A home mortgage loan is viewed more favorably than a payday loan. Additionally, having a mix of revolving credit loans (like credit cards) and installment loans (like auto loans) can be more beneficial than having just one type of loan. Also, be aware that you gain a slight credit score edge by having a credit card from a major issuer, rather than from a department store. While type of debt doesn’t have as large an impact as your credit utilization, it still matters.
Bottom Line
Your debt impacts your credit score, which is one of the most important numbers in personal finance. A credit score can influence how much you pay in interest, whether you get the loan you want, and even your insurance rates. How much debt you have, and the kinds of debt you have, matter in credit scoring, and can mean the difference between being approved with good rates, and having your loan application rejected. The first step to improving your credit score is to know what it is. Here’s how to get a free credit score without using a credit card if you don’t already know your score.
Neal’s notes — Thanks Miranda….I learned a lot about the nuances of debt and credit score. It convinces me even further how important it is to get out of debt fast.
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