Managing Debt & How It Affects Your Credit Score

Your debts have an important relationship with your credit score, but this relationship can be difficult to understand. It has many components, and maintaining the right balance of debt can be tricky without proper information. In this blog, we’ll break down the different kinds of debt, how debt affects your credit score, and how to manage your debts in order to achieve or maintain a good credit score.

Understanding Debt

There are many different types of debt, but the most common types are mortgages, student loans, auto loans, and credit card debt. The first three are installment loans, meaning you borrow a set amount of money at once and pay it back over time. But credit cards are a revolving line of credit, meaning you can borrow money up to a certain amount, pay it off, then borrow again.

Most debts can be categorized into either “good” or “bad” debt. Good debt is an investment that grows in value. This can include student loans and mortgages. Bad debt is when you borrow for something that you lose money on. Credit card debt can quickly turn into bad debt, since credit card companies charge interest for every month that you make only a partial payment.

How Debt Affects Your Credit Score

Your credit score is a representation of your creditworthiness, and it’s used by lenders to assess how likely you are to repay your loan responsibly.

Here are the different factors used to determine your credit score and how debt affects each of them:

• Payment history (35%): This reflects whether you pay your bills on time. Missing payments can negatively impact your score, and failing to pay a debt or defaulting on a loan will severely damage it. Making your payments on time and in full is the single most important practice to maintain a healthy credit score and stay out of financial trouble.
• Credit utilization (30%): This measures how much of your available credit you’re using and is mostly focused on revolving debt, like credit cards. Borrowing too close to your credit limit can signal that you’re overextended, which lowers your score. Try to keep your credit utilization below 30%.
• Length of credit history (15%): The longer you’ve had credit, the better it is for your credit score.
• New credit (10%): Opening too many new accounts in a short period of time can negatively impact your credit score.
• Credit mix (10%): Having a variety of credit accounts, such as credit cards, a mortgage, and a car loan, can be beneficial. It signals to lenders that you are able to handle different types of credit responsibly.

Debt Repayment Strategies

If you have fallen behind on your debts, you have options for getting them and your credit score back under control.

• Debt snowball method: With this method, you begin by paying off your smallest debt first, while making minimum payments on your other debts. Then you take the amount you were paying for that debt and pay it toward your next smallest debt, and so on until you have paid all your debts. With each debt you pay off, you have more money available every month to make even larger payments toward your next debt.
• Debt avalanche method: This method is similar, but it prioritizes paying off debt with the highest interest rate first to save you money on accrued interest. Every time you pay off a debt, take the amount you were paying for it and put it toward the debt with the next highest interest.
• Debt management plan: If you’re having trouble keeping up with multiple monthly payments, you can go to a credit counseling agency for help. These organizations may put together a debt management plan in which you make a single monthly payment to them, and then they make payments on your debts.
• Debt consolidation loan: Similar to what a debt management plan can do for you, debt consolidation allows you to combine all of your debts into one monthly payment by taking out a new loan, typically with a lower interest rate.

Stay on Top of Debt to Maintain Your Credit Score

While there are many moving parts in the relationship between debt and your credit score, what’s most important is that you stay responsible. It can be good to invest in things that have a high return in value. But don’t borrow more than you can afford to pay off. Remember, making your monthly payments on time and in full is the best way to maintain a good credit score.
If you have questions about debt and credit, SharePoint Credit Union is here to help. Visit our financial resource center or contact us today!