Credit and debt are intertwined in more ways than one. The amount of debt you carry can impact your credit score. In turn, your credit score can impact the amount of credit and terms potential lenders may offer.
The Impact of Debt on Credit
Here’s the good news: Carrying debt doesn’t automatically mean your credit is negatively impacted. In fact, it could be just the opposite – it all depends on how you manage it. Do you carry large amounts of credit card debt and pay only the minimum amount each month? Then the impact is likely negative. Do you pay off your credit card balances monthly and make all installment loan payments on time? Then the impact is likely positive.
What is Your Debt-to-Credit Ratio?
Simply put, your debt-to-credit ratio is exactly what it sounds like: the amount of revolving debt you are carrying at a given point in time, compared to the amount of credit available to you. This applies to revolving accounts – lines of credit you can borrow from and pay off over time, like credit cards and home equity lines of credit.
While credit scoring models weigh factors differently, your debt-to-credit ratio — otherwise known as your credit utilization — tends to carry a fair amount of weight. For instance, credit utilization makes up 30% of your FICO score, while VantageScore deems it “extremely influential” in determining your credit score. But it’s also important to note how they look at credit utilization as a whole.
- VantageScore 4.0 (the latest VantageScore model) considers your credit utilization trend over time. Do you normally pay your balances in full? Or do you always pay just the minimum balance?
- FICO and older VantageScore models just take a snapshot of where your balances currently stand in comparison to your available credit.
There’s not a hard, fast rule for where your credit utilization should fall, but the general rule of thumb is 30% or lower. Here’s how to calculate yours:
- Step 1: Make a list of all of your revolving credit accounts.
- Step 2: Add up the credit limits for every revolving credit account.
- Step 3: Add up the current balances for every revolving credit account.
- Step 4: Divide your total balance amount by your total credit amount and multiply by 100. This number is your credit utilization – or the total amount owed as a percentage of credit available to you.
Debt-to-Credit vs. Debt-to-Income
While your debt-to-credit ratio (or credit utilization) does directly impact your credit score, your debt-to-income ratio does not. It does, however, impact your ability to get approved for certain types of credit.
Your debt-to-income ratio is calculated by adding up all of your monthly debt payments (including those for non-revolving debt, such as auto loan payments and mortgage payments) and dividing that by your monthly, pre-tax (gross) income, and multiplying that by 100. However, in certain circumstances — like when you’re buying a home — lenders will take this a step further and consider your front-end ratio and back-end ratio. Here’s what that means:
- Front-end ratio: This is your total monthly housing expense divided by your total monthly gross income and multiplied by 100.
- Back-end ratio: This is your total monthly debt payment divided by your total monthly gross income and multiplied by 100.
According to the Consumer Financial Protection Bureau (CFPB), 43% is generally the highest debt-to-income ratio a borrower can have to be approved for a qualified mortgage. There are exceptions, but this is their general rule of thumb.
Credit Card Debt 101: How it Works
While having credit card debt doesn’t necessarily mean your credit score will be negatively affected, the size of your balances and the way in which you pay them could potentially have an impact.
Average Credit Card Debt in America
If you’re carrying credit card debt from month to month, you certainly aren’t the only one. According to data compiled by ValuePenguin, as of April 2020 41.2% of American households carry credit card debt, with an average balance of $9,333.
Check out a few interesting findings from ValuePenguin’s survey.
- State with the highest average balance: Alaska with $13,048
- State with the lowest average balance: Ohio with $5,446
- Age bracket with the highest average balance: 45-54 with $9,096
- Age bracket with the lowest average balance: 75+ with $5,638
The Impact of Credit Card Debt
So how does credit card debt contribute to your credit score? A few different ways.
- Credit utilization
As discussed above, credit utilization — the size of your total, outstanding balance that you owe on all of your revolving credit accounts at a given point in time, compared to the amount of credit available to you – makes up a significant part of your score. If credit cards are the only type of revolving credit you have, this becomes even more significant.
- Payment history
Payment history — or how many payments you’ve made on time and how many payments you’ve missed — is also a key factor in determining your credit score. By paying at least your minimum credit card payment on or before your due date each month, you can make sure the effect is positive.
- New credit
While less influential, the number of new credit accounts you have also impacts your score. So when it comes to credit cards, it’s likely better for your score if you don’t open multiple cards at one time.
- Credit history
Credit history is the average length of time all of your credit accounts have been open – the longer the better. Avoid opening up multiple credit card accounts at once and consider leaving old credit card accounts open as both of these moves can lower your average credit age.
How to Pay Off Credit Card Debt
If you’re struggling with a large amount of credit card debt, chances are your credit is feeling the impact. The good news is, there are options to help you in the payoff process.
Debt consolidation is generally referred to as the process of using a personal loan or balance transfer credit card to pay off different accounts for the purpose of getting a lower interest rate and/or creating a payment plan that’s easier to follow.
If you’re deciding between a personal loan or a balance transfer credit card, there are a few things to consider.
- Is there a promotional offer?
Sometimes balance transfer credit cards will offer an introductory rate in which new purchases or your balance transfer amount won’t be charged interest for a certain amount of time. Just beware, if you don’t pay off the amount owed during this promotional period, you could be charged interest on the entire balance transfer amount.
- What are the fees?
From loan origination fees to credit card balance transfer fees, both options are likely to come with certain costs attached. Make sure you know what you’re in for before making a decision.
- What’s better for you?
If you’ve struggled with racking up large credit card balances, having access to a line of credit through a balance transfer credit card might not be the best option. On the other hand, you may have a hard time making the set payments required with a personal loan. Consider all angles of both options and choose what’s right for you.
Debt Consolidation & Your Credit
One benefit to debt consolidation is the positive impact it could potentially have on your credit. Here are a few ways it can help:
- By improving your credit utilization.
If you pay off your credit card balances with a balance transfer credit card, the credit limit of the new card will be added to your existing credit limit. Therefore, the percentage of debt vs. credit will be lower. If you pay off your credit card balance with a personal loan, you could potentially bring your credit utilization even lower. This is because a personal loan is an installment account while your credit utilization is a measurement of debt carried on revolving accounts (e.g., credit cards).
- By improving your credit mix.
While credit cards are revolving credit accounts, personal loans are installment credit accounts. Since a portion of your credit score (albeit a small one) is dependent upon having a mix of different credit accounts, opening a personal loan could potentially give your score a boost.
Top Picks for Debt Consolidation Loans
If you’re on the hunt for a debt consolidation loan that would work for you, there are plenty to potentially choose from.
- Marcus: by Goldman Sachs
The draw: No fees
Interest rates range from 6.99% to 28.99% and loan amounts range from $3,500 – $40,000.
The draw: Low rates
Interest rates range from 3.49% to 16.79% and loan amounts range from $5,000-$100,000.
The draw: A personal loan specifically for credit card debt consolidation
Interest rates range from 5.99% to 24.99% and loans amounts range from $5,000-$35,000.
- Discover Personal Loans
The draw: Flexible repayment terms and no fees
Interest rates range from 6.99% to 24.99% and loan amounts range from $2,500-$35,000.
[From helpful usage tips to top credit cards, we have everything you need to know about buying on credit here.]
How Different Types of Debt Impact Your Credit
Did you know the impact debt has on your credit could depend on the type of debt you’re carrying? Find out what that could mean for your credit report and credit score.
Medical debt is often unexpected and overwhelming. But the good news is, it shouldn’t show up on your credit report unless it is sent to collections (which generally doesn’t occur until it’s 60-180 days past due, depending on the provider). From there, all three Credit Reporting Agencies (CRAs) are required to wait an additional 180 days to include this information on your credit report, allowing ample time to settle the debt, have your insurance company pay, or reach another resolution. If medical debt has been added to your credit report, there are a few things you should know:
- The impact medical debt has on your credit score may depend on the scoring model.
FICO 9, as well as VantageScore 3.0 and 4.0 place less weight on medical debt in comparison to other types of debt in collections.
- The size of the debt matters.
If it is less than $100, for instance, FICO 9 won’t take it into account at all.
- If your insurance company takes responsibility for the charges, you’re in the clear.
If your insurance company agrees to pay the charges sent to collections, all CRAs must remove the information from your credit report.
Some student loans may not require a credit check, but they will all likely have an impact on your credit eventually. Whether the impact is positive or negative depends largely on how you manage them.
- Loan balance:
While the total amount of student loan debt you have doesn’t have a direct impact on your credit score, it is reflected on your credit report and could impact future lending decisions.
- Payment history:
As long as your loans are not in deferment, making on-time payments is very important.
- Credit mix:
Variation in the types of credit you have — like credit cards and student loans, for instance — can have a positive impact on your score.
- Credit history:
Student loans could potentially be the first form of credit you have which means, not only can they begin to establish your credit, but they can serve as your longest standing credit account later on.
While carrying debt from an auto loan is not negative in and of itself, there are a few potential impacts you should keep in mind.
- Credit inquiries:
Rate shopping for the best auto loan? The number of hard credit inquiries you have can negatively impact your credit, at least for a short amount of time. [Find out the difference between “hard” and “soft” credit inquiries.] To lessen the impact, make sure to apply for any auto loans within a two-week span, always apply for the same amount, and avoid applying for other types of credit at this time.
- Payment history:
Just like all other types of credit we’ve discussed, making auto loan payments on time can give your payment history — and credit score — a positive boost.
- Credit mix:
Auto loans are another type of installment loan that can show future lenders you have experience managing different types of credit.
The impact taxes can have on your credit is a bit trickier to pin down. First of all, the IRS does not report on-time payments to CRAs so if you’ve always filed on time and paid in full, there is neither a positive nor negative effect. However, in theory, if they transfer your unpaid tax debt to a debt collector, that debt collector could potentially report it to the CRAs.
In the past, tax liens — a claim placed on your owned property as a result of unpaid taxes – showed up on credit reports for 7-10 years (up to seven years if it was paid and up to 10 years if it was unpaid). Due to issues with inaccurate reporting, all tax lien information has been removed from credit reports as of April 2018.
Credit, Debt, & Financial Hardship
What happens when accumulating debt is the result of a hardship that’s out of your control?
This has become the reality for many due to the recent coronavirus outbreak. According to The New York Times, as of April 6, the unemployment rate could, by some calculations, be sitting at 13% — the highest it’s been at any point since the Great Depression. The staggering number of unemployed means many will be unable to make monthly loan payments and will be relying on credit cards more than normal.
Fortunately, there are some credit protections available in these types of situations.
Disaster Reporting Codes
One way VantageScore works to protect consumer credit scores in times of crisis is by taking into account a code lenders can use to indicate borrowers are financially impacted by a natural disaster, or, in this case, a public health emergency. While this code is in effect, negative items added to your credit report are set to neutral.
(Remember, you have multiple credit scores and not every credit scoring company will take a disaster reporting code into account the same way.)
Forbearance and Deferment Options
You’ve likely heard the terms “forbearance” and “deferment” used interchangeably when it comes to financial relief in the coronavirus age. Here’s what these terms mean:
- Forbearance: The temporary suspension or reduction of payments. Generally, interest continues to accrue and the missed or reduced payments are due at the end of this period (unless another plan is set in place).
- Deferment: The temporary suspension of payments, and potentially interest as well. Deferred payments may be added to the end of the loan, or be paid back in intervals agreed upon by both parties.
Part of the CARES Act, the federal government’s stimulus package, stipulates that a loan placed in forbearance or deferment should be reported to the CRAs as “current” not “delinquent” (as long as it is current before the forbearance or deferment period begins). FICO takes these terms into consideration when calculating your score, ensuring this temporary pause in loan payments doesn’t negatively affect your score.
The Bottom Line
Carrying debt doesn’t spell doom for your credit. However, the amount you have and the way you manage it can have a lasting negative impact. Before taking out a loan or charging your credit card, make sure you know how it works — and plan accordingly.