Debt can help or hurt your credit score, depending on how it’s used
How debt affects credit scores
- High revolving credit card balances and fixed installment loans are both considered in determining a person’s credit rating.
- Credit reporting agencies look closely at credit-utilization, or the proportion of credit balances in relation to the available credit.
- Using cash to make all purchases will not help your credit score.
- Using a credit card responsibly can help establish credit and help your score.
- Credit card balances of more than 30 percent of the available credit line hurts your credit score.
You need a healthy credit score to qualify for home or auto loan, to convince a landlord that the rent will be paid on time and to get a better interest rate. Establishing good credit, then, can mean the difference between getting a loan or not, and it can lower borrowing costs too. Building up too much debt, however, is one way to destroy your rating.
Carrying a lot of debt, particularly on credit cards, can dramatically lower your credit score. According to FICO, the most widely used credit-rating standard, a person’s debt level accounts for 30 percent of the credit-score calculation. The rating agencies look carefully at a person’s credit utilization — or the proportion of your credit balances in relation to the available credit lines. The closer you come to maxing out a credit card, the worse it is for your score.
Credit card use is not the only factor, however. The reporting agencies also evaluate the borrower’s so-called credit mix, which includes both the revolving debts from credit cards and installment loans, which are typically fixed-interest loans paid off over time — such as auto loans and mortgages. While this isn’t typically the biggest factor in calculating the score, if you have a solid history of paying both revolving and installment loans, it can boost your score.
FICO also factors in the balance on the installment loans. If the balances have been paid down, it’s better for your credit score.
Myths credit scores
There are several myths about debt and its impact on credit scores.
One common myth is that a person needs to carry a lot of debt initially on the cards to boost their score. Credit counselors advise that it will help your score if you maintain at least one credit card line, and use it to establish credit. Paying for everything with cash will not help your score, but using a credit card responsibly establishes a credit history. The longer you have this credit history, the better it is for your score.
However, you should be extra cautious about racking up credit card debt. Charging up large balances or maxing out a card will hurt your credit score by driving up the card-use rate. It also puts you at risk of overextending yourself and missing payments, which is one of the fastest ways of lowering your credit scores.
It is a better idea to pay down the card each month and keep balances as low as possible. You should rack up a balance no more than 30 percent of the extended credit line, anything above that hurts your score, according to the Association of Independent Consumer Counseling Agencies.
Another mistake people make, according to credit counselors, is opening or closing out several credit cards at once. If you open several new lines, particularly if you do not have a long payment history, it is viewed as risky and can hurt your credit score.
It also is not a good idea to close out several accounts at once and leave a large balance on just one or two credit lines. Remember that the credit-reporting agencies look carefully at the proportion of the debt in relation to the person’s available credit. Paying off debts lowers that proportion, but closing accounts can raise the debt-use proportion and hurt your score.