How Does Debt Affect Your Credit Score?

It's unlikely you'll live your entire life without debt. Whether it's student loans, a car loan, a mortgage, or even credit card debt, owing money to lenders is something that almost all Canadians go through at one point or another. Managing your debt responsibly can help you maintain a good credit score.   

Unpaid debt can have a significant impact on your credit score, especially if it’s been sent to collections. If you manage your debt poorly and don’t pay it back on time, your credit score will drop. But not all debt is bad for your credit score. If you handle your finances responsibly, paying back debt can actually help you improve your credit score. You can take on student loans, a car loan, a mortgage, or even carry credit card debt while maintaining a good credit score.

There are vital factors that determine your credit score, and those factors are heavily influenced by how you manage your debt. These factors include your credit utilization ratio, your credit mix, and your overall debt levels. Here's how to manage your debt so that it doesn't negatively impact your credit score.

How Your Debt Affects Your Credit Utilization Rate and Your Credit Score 

Your credit utilization rate is your credit balances as a percentage of your overall credit limits. For example, if you have a credit card with a $5,000 limit and a $1,000 balance, your credit utilization rate is 20%. Canada's credit bureaus prefer if your credit report has a credit utilization rate under 30%. If you plan to carry a balance, you can protect your credit score by making sure you don't owe more than 30% of your limit.

You can also simplify this calculation by striving to keep a zero balance on all of your revolving credit accounts. You can do so by making purchases you know you can afford. Use your own cash that you have available to pay off revolving credit quickly. The same goes for installment loans, since your credit score also considers how close your loan balances are relative to your original loan amount. The more you pay off your loans, the better your credit score.

How Your Debt Affects Your Credit Mix and Your Credit Score

Your credit mix is the number of different types of credit you have on your credit report. Credit bureaus like to see a good mix of credit tools (for example, a credit card, a car loan, and student loans) because it indicates that you can manage multiple debts successfully.

It's important to note that you don't have to carry debt to have these credit tools count toward your credit mix. A credit card with a zero balance will improve your credit mix just as much as a credit card with a $1,000 balance. So it's wise to keep those credit accounts open to improve your credit score, but keep the balance low or at zero to avoid interest charges. Just remember that an inactive credit card could be suddenly cancelled by your provider after a certain amount of time, which could hurt your credit score. To keep the card open, make small purchases every once in a while or use it to auto-pay a regular bill. 

Debt and Your Financial Health

While having multiple credit types with low balances is an excellent way to get a positive credit rating, the most financially responsible way to handle your debt is to pay it off as quickly as possible. When you keep your credit card debt and other debt to a minimum, you'll insulate yourself from financial catastrophes by:

• Ensuring less money in your monthly budget is taken up by minimum payments

• Spending less of your hard-earned cash towards interest charges

• Freeing up available credit to handle emergencies

• Making your money available to save for emergencies

In particular, you should avoid credit card debt at all costs. Credit card debt is subject to very high interest rates, making it difficult to pay back those charges promptly. If you have a lot of credit card debt, hundreds of dollars of your monthly payments could end up going towards interest charges, leaving less money to pay down the principal. These high interest charges can quickly snowball, resulting in a higher than desirable credit utilization ratio, or even worse, late or missed missed payments.

Your payment history is the largest factor that impacts your credit score. Having too much debt can make it extremely difficult to pay back your debt on-time. Late or missed payments debt payments can cause your credit score to drop. This is especially true if a debt payment has been sent to collections by your lender. A collections item can tarnish your credit score, and this negative information can remain on your credit report for 6 years. If you don't pay off an account in collections, then it could remain on your credit report indefinitely. To keep your credit score healthy in the long-run, it's essential that you pay off any debts in a timely manner.

Finally, your debt impacts more than just your credit score. Whenever you apply for a new loan, whether a car loan or a mortgage, your lenders will scrutinize your debt levels to ensure you can afford the new loan. Your lender will use your debt to income ratio to determine whether you are a good candidate for more lending. If you carry high levels of debt already, you are more likely to be denied these potentially life-changing loans. Many Canadians have been denied mortgages or student loans due to the simple fact that they could not keep their credit card debt under control.

You Don't Need a Credit Card Balance to Build a Credit Score

While your credit score is heavily impacted by the types of debt you have and the balances you carry, you don't need to carry debt to have an excellent credit score. There are even ways for you to build credit without using a credit card. What's far more important is having several different credit products in good standing on your credit report and keeping your debt balances as low as possible, or ideally, at zero. If you stick to these two guidelines, you'll have a credit score you can be proud of.