How Your Debt Affects Your Credit Score

How Your Debt Affects Your Credit Score

Written by Caitlin Wood
Last Updated June 2, 2021

Many consumers are not aware of how their debt affects their credit score and may end up sabotaging efforts to improve overall rank. As plastic beckons with alluring promotions it becomes increasingly important to know how banks and other institutions measure risk and how to make your payments to keep them manageable and to maintain positive credit ratings. With companies requiring deposits based on your score it is important to keep it as high as possible so read this article and learn how your debt affects your credit score and methods to improve your ratings.

5 Ways Your Debt Affects Your Credit Score

There are many common misconceptions regarding bank and credit card debt and its impact on your credit score. As credit score becomes increasingly important in many aspects of daily life, from applying for insurance to renting a home or apartment, it is crucial to understand how it works. Learning how your payments, debt consolidation and overall debt impact the numbers can help you make wise decisions.

1. Credit card companies, as well as banks, typically extend more cards and higher credit limits to customers who make regular payments, including those who just make the minimum monthly payment. The high interest rates charged by most credit card companies tends to be considerably higher than a bank is able to charge for a traditional loan. Although they are carrying a balance, the interest continues to accrue, and consumers eventually have even higher balances due to compounding interest. The monthly minimum may never make a dent in the principal, and you will eventually pay for the purchase many times over by making only a small regular payment. Banks will look at this and consider whether the principal is being paid down or whether you are only able to meet the minimum payments when you apply for a loan.

2. The length of time you have had a credit card, your payment history, and its interest rate, and how many cards you have altogether, are all factors that are considered by banks when you apply for a loan. Banks prefer to see a debt to credit ratio of less than 30%, and definitely less than 50%. But they also register danger signals when they see a lot of new credit has been applied for or that you can potentially run up a lot of debt on numerous credit cards. It is best to keep only 2 or 3 cards with low interest rates, a regular payment history, and low balances. For instance, having two cards at 30% total balance, rather than a single card at 60%, could help improve your credit score (so long as the total credit on both cards is greater than the credit available in the first single card holding a balance of 60%).

3. The type of debt you carry also affects your credit score. The payment history, total balance, and number of college loans, home loans, lines of credit, and car loans will also impact your credit score. Banks want to see regular payments with decreasing balances. They also want to know that consumers are financially savvy, perhaps choosing to use a line of credit or personal loan to pay off high interest credit cards. When choosing this avenue, always be sure to cancel the credit cards to decrease the risk of doubling overall debt.

4. A stable regular income assures a lender that you will be able to make the required payments in a timely fashion. Each lender will have a different current and proposed debt to income ratio they use to decide whether you are a good credit risk and whether you will be able to service the debt. This ratio may also affect your interest level, with higher risk borrowers forced to pay higher interest rates. Your overall credit score, payment history, and available credit, is also calculated into these rates.

5. There are good ways that your debt affects your credit score, including carrying a variety of different types of credit. If you currently have only credit card debt, the addition of a mortgage or home improvement loan can increase your overall score. One caveat to this, is to borrow only what is needed, its wiser to take time and perseverance to allow a natural rise in credit than to go deeper in debt to raise the score.

Although a high credit score makes it easier to borrow money, it can be easy to take on more debt than you can afford, which will eventually have a negative effect on your credit score. Use credit cards and loans wisely, as they are not adding to disposable income, but will have to be paid off using future earnings. Carefully look at the terms of the note or credit extension, checking interest rates to determine whether you will be able to afford payments that will lower the principal as well as keeping up with interest. How your debt affects your credit score will influence your ability to obtain insurance, rent a home, connect utilities and borrow money in the future.

Caitlin Wood is the Editor-in-Chief at Loans Canada and specializes in personal finance. She is a graduate of Dawson College and Concordia University and has been working in the personal finance industry for over eight years. Caitlin has covered various subjects such as debt, credit, and loans. Her work has been published on Zoocasa, GoDaddy, and deBanked. She believes that education and knowledge are the two most important factors in the creation of healthy financial habits. She also believes that openly discussing money and credit, and the responsibilities that come with them can lead to better decisions and a greater sense of financial security.

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