Your Debt and Credit Scores
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Debt has a direct impact on your credit scores. Owing money on loans and credit cards doesn’t necessarily ruin your credit—in fact, you can’t build up credit scores without borrowing money—but you can get in trouble if you borrow more than you can afford to pay back.
As your debt grows, however, you may see your credit scores fall. Even worse, missing a debt payment can result in late fees, high interest charges and long-term damage to your credit scores.
But it’s important to remember that your credit scores aren’t set in stone. In other words, no matter how bad your scores are, you can always improve them by practicing healthy debt management habits. Here’s what you need to know.
How Does Debt Affect Your Credit Scores?
Each person has multiple credit scores, and your scores can vary a bit depending on where you pull them and who does the score calculation. But regardless of which score you review, the number you see will be a direct reflection of how you manage your debt. The better you are at honoring your agreements with creditors and borrowing within your means, the higher your credit scores will be.
Your FICO credit scores are based on five areas of debt management. Here’s what they are and how much weight each one has on your credit scores:
- Debt payments (35%): Your history of making credit card and loan payments on time over the last 7 to 10 years.
- Amounts owed (30%): How much of your available credit card limit(s) you’re using.
- Length of account history (15%): The average length of time you’ve had your debt accounts open.
- 10% Credit mix: Whether or not you’ve managed different types of debt responsibly (e.g. student loans, credit cards or a mortgage.)
- 10% New credit: The number of applications you’ve made for credit cards and loans in the last year.
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It’s important to remember that your credit scores aren’t set in stone. In other words, no matter how bad your scores are, you can always improve them by practicing healthy debt management habits.
Here’s a closer look at the two areas that have the biggest impact on your scores:
Debt Payments
More than a third of your credit score calculation is based on whether or not you make your debt payments each month. If just one late payment appears on your credit report, it can have a major effect on your scores, and you could see them drop by 80 points or more.
What is a late payment? If you fall behind on your credit card or loan payment by 30 days or more, it can be reported as “late” to the credit bureaus and it will remain on your credit reports for seven years.
Amounts Owed
Thirty percent of your credit scores is based on how much of your available credit you’re using. The higher your balance is in comparison to your credit card limit or your original loan amount, the lower your scores will be.
You can improve your credit utilization, or debt-to-credit ratio (DTC), either by paying down your balance or by requesting a limit increase (for credit cards).
Contrary to popular myth, there is no ideal DTC you should aspire to. According to FICO, the goal should simply be to have a low DTC. But that doesn’t necessarily mean maintaining 0% at all times, since your creditor may close the account if it’s inactive for several months.
Does Paying Off Debt Help Your Credit Scores?
In most cases, paying off debt will cause your credit scores to grow. Each time you make an on-time payment on a credit card or loan you build positive credit history. As you pay down your debt and reduce your DTC, you’ll also see your scores improve.
But there are a few exceptions to this rule. Some behaviors associated with reducing debt can indirectly hurt your credit scores. Here are a few moves that can cause your scores to drop:
- Closing credit cards: Closing a credit card reduces your available credit and can raise your DTC.
- Inactive accounts: If you go for months without using your credit card, the creditor may close your account, which reduces your available credit.
- Never using credit: If you’ve never had a credit card or loan, you probably don’t have credit reports or scores at all.
Five Reasons to Monitor and Improve Your Credit Scores
You can monitor your credit reports for free by pulling all three of them (from Equifax, Experian and TransUnion) from AnnualCreditReport.com as often as once a week. Many people have free access to a version of their credit scores as a complimentary feature of their credit card(s) as well.
Here’s how you can benefit from monitoring your credit information and building your scores:
1. Access to Housing
When your credit scores are low, you might be turned down for rental homes/apartments or get declined for a mortgage. If you wait to work on your credit until you need housing ASAP, you probably won’t have time to make the necessary improvements.
2. Catch Signs of Fraud
Looking at your credit reports can help you catch major red flags for identity theft, including:
- Unfamiliar credit applications.
- Accounts that don't belong to you.
- High account balances that don't match your spending.
Additionally, an unexpected dip in your credit scores can be a sign that someone has used your information to open a credit account or rack up debt.
3. Qualify for Better Loans and Credit Cards
Borrowing money is more expensive when you have low credit scores. For example, Forbes Advisor reports that the average interest rate on a credit card is 16% to 18% for people with credit scores of 740 or higher, but it jumps to 24% for people with scores below 580.
If you fear getting declined every time you apply for credit: Find an option tailored for you.
4. Security Clearance
Having poor credit can prevent you from getting or keeping certain jobs. Some military roles, for example, require security clearance, which can be revoked if a missed payment or other negative marks appear on your credit reports.
5. Fix Errors
Around a third of credit reports have errors on them. Some of the errors are harmless, like an incorrect spelling of your name. But monitoring your reports can help you find and address the more serious errors, like a payment that shows as missing even though you made the payment on time.
Disclosure: Consumer Insite has partnered with CardRatings for our coverage of credit card products. Consumer Insite and CardRatings may receive a commission from card issuers.
