Debt is a growing problem in many households across the U.S. – and it doesn’t look like it’s going away any time soon. Millions of Americans are carrying increasing amounts of debt because while its easy to get into, it can be very challenging to get out of. As people struggle to overcome debt, their situation can become even worse because of the impact it has on their credit score.
Does debt affect your credit score? The short answer is yes, but how serious is the impact – and what can you do about it?
Read on to see our answers to three common questions about debt: how does debt impact your credit score, how does your credit score impact your debt, and how can you rehabilitate your score once you’ve fallen into debt?
Does Debt Affect Your Credit Score?
What impact does debt really have on your credit score? Will debt leave you with a terrible score for the rest of your life? Don’t panic just yet, but keep in mind that debt plays a major part in determining your credit score.
A credit score is a number generated by a mathematical algorithm that predicts how likely you are to pay off your debt.
- Payment History (35%)
- Amounts Owed (30%)
- Length of Credit History (15%)
- New Credit (10%)
- Credit Type (10%)
Debt falls into the two most heavily weighted categories: Payment History and Amounts Owed. These categories account for over 50% of your credit score, making them a significant contributing factor. Debt on a credit score is not necessarily a bad thing. Whenever you use your credit card, that amount is the debt you owed. You need that debt in order to build your credit history. To put it in simpler terms, you need a history of spending and paying off your debt to show you are reliable. It’s important to remember that the whole purpose of a credit score is to show lenders that you can be trusted to pay back whatever they lend you.
However, there are two major ways your debt can damage those categories of your credit score: missed payments and credit utilization ratio. Missing payments includes not paying bills, rent, or paying off your credit card. Missed payments affect your payment history, which accounts for 35% of your total credit score.
Your credit utilization ratio tells you the relationship between your total monthly debt and your available monthly credit. In order to keep your credit score high, this ratio should never exceeds 30%. For example, if you have a credit card with a $1,000 credit limit, you should carry a balance of no more than $300 in order to avoid negative marks on your credit score.
How Does Your Credit Score Impact Your Debt?
The fact that debt can be damaging to your credit score will not come as much of a surprise to most people, but were you aware that your credit score can actually cause your debt to grow? Remember, credit scores tell lenders how reliable you are when it comes to paying back loans. If your score has taken a hit because of your debts, lenders will increase their interest rates on your loans in order to make their risk worthwhile.
As you can see, the symbiotic relationship between your credit score and your debt can create a loop that many people just don’t know how to escape. If your credit score is low due to debt, don’t fret – there are ways to fix this problem.
How to Rehabilitate Your Credit Score
If you are able, the best thing you can possibly do to rehabilitate your credit score is to pay back debt. Limiting your spending and chipping away at your debt is the best first step you can take to improve your credit. However, many people dealing with debt don’t have the money needed to pay everything back. Unfortunately, nothing improves your credit score more than paying off bills on time. But there are ways you can cushion the blow.
Steps you can take include:
- Make payments on time every month.This simple but important habit will naturally raise your score over time.
- Avoid closing credit cards or accounts. Doing so reduces the average age of your credit, which is another important part of your score.
- Use your personal checking debit card instead of a credit card. This will help you avoid racking up credit card debt. Try to use your debit cards for your cash back checking account and triple rewards checking account if you can.
- Pay attention to your interest rates. If a particular loan or credit card has a particularly high interest rate, consider refinancing or focusing on getting that loan paid off.
- Open a savings account to cover unexpected expenses so you don’t have to always rely on using credit.
- When emergencies occur and you need access to funds, consider a Home Equity Line of Credit instead of using a credit card. With lower interest rates and a longer payment term, you won’t damage your score the way you would with a credit card.
One of the most important things you can do through this process is recognize that improving your credit score doesn’t happen over night. It requires disciplined financial planning and patience.
We Can Help
Want to improve your credit score but not sure where to start? We can help. One of our Union Trusted Advisors can access your FICO credit score and perform a full credit review. We go over your credit score with you and discuss how you can improve your score, how to get out of debt, and create a plan with you that helps you manage your debt in the future. Contact your local Union Community Bank branch today and schedule a credit review with a Union Trusted Advisor.