Definitive Guide to a Debt Free Life – Chapter 5: How Debt Affects Credit

Good job for getting this far in The Definitive Guide to a Debt Free Life!! You are well on your way to living the debt free life that you deserve.

In Chapter 4, you learned what it takes to get, read, and understand your credit report, a very important financial tool. You now have the skills you need to interpret the information displayed on your credit report, the same information seen by creditors and financial institutions everywhere.

But you still do not know exactly how your debt affects your credit.

So to make sure that you know how your credit card and loan decisions affect your credit score, this chapter will focus on how debt affects credit.

The chapter will also touch on how different types of debt relief can affect your credit report.

Your Debt Load

The amount of debt that you have is one of the biggest ways in which debt affects credit.

In fact, the total amount of debt that you have, otherwise known as your debt load, accounts for 30 percent of your overall credit score.

Credit utilization is a big factor when it comes to your debt load. Credit utilization is the ratio between your debt balance, say on a credit card, and the specific debt’s credit limit, such as your credit card’s limit.

Your credit score is negatively affected when you have used a higher percentage of your overall credit limit than when you have used a lower one. The worst factor for the debt load section of your credit score is a maxed-out credit card.

The current amount you owe on a loan or credit card is also taken into consideration. The figure is compared to that of your original starting balance. Your credit score improves when the amount that you currently owe is lower than the original starting balance. This is because paying off your loans in a timely manner raises your credit score.

Simply put, carrying a lot of debt, especially when your debt-to-credit ratio is high, is generally not a good thing for your credit score. It furthermore affects your ability to receive new loans or be approved for new credit cards. (About.com) 

How You Handle Your Debt

Nearly as important to your credit score as your debt load is how you handle your debt.

The manner in which you pay off your debts is of utmost importance. When you pay off your debts quickly and stay current on your monthly payments, your credit score will increase. At the same time that you are lowering your balances, you are also lowering your overall credit utilization.

Naturally, the opposite is also true. If you fail to meet your monthly payments and hold onto your debt for longer than you should, your credit score is going to suffer.

Your credit will most positively be affected when you pay off your debt yourself, on time and in full. But not everyone is able to tackle their debt problem alone, especially when they have fallen behind in the past.

In instances like these, debt relief is needed. But debt relief can oftentimes hurt your credit score. We will talk more about debt relief and your credit score later on in this chapter. (Credit.com) 

Can Debt Help Your Credit Score?

Many people believe that having debt can help their credit score. In fact, a lot of people believe that carrying debt is one of the only ways to improve their credit ratings.

This is not actually true. Of course, carrying a credit card balance has its credit benefits – when charges are paid off in a timely manner, your credit rises – but if this balance is on your report for too long, your score will drop. Carrying a balance that is too high will bump down your credit score. 

Only 10 percent of your credit score is affected by the types of debts, otherwise known as accounts, you have. Your credit rating improves when you have experience with a wide variety of different types of accounts.

For instance, taking out a mortgage could positively affect your score if you have never had one before. In fact, balancing out the types of accounts that you do have – between credit cards and other types of loans – can be a good thing.

However, you should remember never to take out a loan just because you want to improve your credit rating. Doing so is a plain bad idea. Things can backfire in an instant and you might just find yourself missing payments and driving yourself down into debt and poor credit – exactly the opposite of your initial goals. 

Your absolute best bet is to let your credit grow naturally as you borrow money and pay it back as you need it. (MyFICO.com) 

Debt Relief and Credit

As mentioned above, making the most of debt relief services can sometimes hurt your credit.

However, it is worth noting that a slight slump in credit is sometimes a price worth paying if it means eliminating the rest of your debt.

It is also important to keep in mind that it is impossible to precisely calculate how much a particular type of debt relief will affect your credit. Any number of specific individual factors will affect how much each type of relief will affect you in particular.

A few of the most common types of debt relief and how they affect your credit include:

  • Debt Consolidation – A popular method of debt relief is a debt consolidation loan. This type of loan basically combines all of your debts into a single payment, made once per month and often with a lower interest rate. Debt consolidation usually increases your risk factor thus dropping your credit score by a few points. But it really is hit or miss, sometimes your score can actually improve when you consolidate your debts.
  • Credit Counseling – Calling or talking with a credit counseling organization will not affect your score in and of itself. However, if you sign up for a debt management plan and make monthly payments to them, your score could drop slightly. For the most part, FICO and the main credit report bureaus do not count credit counseling as a method of debt relief, so you are generally not penalized.
  • Debt Settlement – Settling a debt means negotiating with your creditors to pay less than the full balance that you owe. Debt settlement will almost always hurt your credit score. At the same time, however, it can also help your credit profile, making it easier to rebuild your credit after your debt is paid off.

(Credit.com)

Knowing how your debts affect your credit rating is very important. This chapter highlighted the various aspects that go into how this works.

In the next chapter of this guidebook, we will explore debt management more closely. The chapter will include how to set up a solid debt plan and a solid money management plan. It will also discuss about budgeting, saving money, and debt repayment. 

Resources 

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