In the financial world all debt is certainly not created equal. There are good debts and there are bad debts. The generally accepted concept is that good debts include those which work for you – investments which may grow in value. Conversely, bad debts are those which will depreciate in value. So what really determines good debt and bad debt on your credit report?
If you have made the mistake of taking on too many debts then it is probably a smart idea to work toward eliminating those debts as quickly as possible. Yet before you decide which debts you plan to pay off first you should remember not to evaluate your debts solely from a financial perspective either. It is also important to consider how the different types of debts you carry may impact your credit. Good debt and bad debt don’t work the same on your credit report, and they’re not scored the same either!
Like it or not, your credit reports and scores have a tremendous influence over your life and your financial wellbeing. Ignoring the impact which paying off a debt may have upon your credit scores could turn into a costly blunder down the road.
Good Debt and Bad Debt: A Credit Scoring Perspective
In the world of credit scoring the types of debt you incur are treated very differently. Of course your payment history matters a great deal regardless of the debt type. A late payment made on your mortgage loan may hurt your credit scores just as severely as a late payment made on a credit card account.
You are probably already well aware that on-time payments are the first key to earning good credit scores. Assuming that you have already established good payment habits the next step is to take a deeper look into how credit scoring models like FICO and VantageScore will treat the different types of debt appearing on your credit reports.
- Installment Debt
From a credit scoring perspective installment debt is considered to be “good” debt or, more accurately, debt which statistically represents less risk. Installment debts, such as auto loans and mortgages, are typically secured by an asset. Other installment debts like personal loans and student loans may not be secured, yet they still represent a lower level of risk to the lender for a variety of reasons.
The purpose of credit scores (specifically the FICO score) is to predict the likelihood that a consumer will become 90 days late on any account within the next 24 months. Installment debts are simply less indicative of this future risk. For this reason the balances on your installment debts will likely have little negative impact upon your credit scores whenever you open a new account. As a result paying off installment debts probably will not do much to improve your credit scores.
- Revolving Debt
The most common example of revolving debt can generally be found in your wallet. Credit card debt is obviously considered to be bad debt from a financial perspective and it is considered bad debt from a credit scoring perspective as well.
When you revolve expensive, outstanding credit card debt from month to month you are both wasting money and harming your credit scores simultaneously. The amount of debt you carry, especially credit card debt, is highly predictive of your future risk. Because of this fact, credit scoring models pay close attention to your credit card balance to limit ratios.
As you tap into more and more of your credit card limits your scores will slide further and further downward. Credit card debt itself can hurt your credit scores, even if you maintain a spotless payment history on your accounts. The good news, however, is that if you pay off your credit card debt your credit scores will generally rebound rather quickly.
The Bottom Line
Now that you understand how good debt and bad debt can impact your credit scores you can leverage that knowledge to your advantage. Working to get out of debt is almost always a great idea. Yet if you can create a plan to tackle your bad debts (aka credit cards) first then might just earn yourself a credit score boost sooner rather than later.