Most of the words that characterize debt are relative, to say the least. “Big”, “crushing”, “manageable” and others give a relative idea about the amount of debt that an individual has but the question remains; what, exactly, constitutes “a lot” of debt?
The answer is simply this; if you can’t make the payments on what you owe, you have too much debt. While it’s true that missing any type of payment will negatively affect your credit score, allotting to much of your income towards paying down debt can hurt your credit as well. The higher your debt to income ratio is, the more difficult it will be to actually take on more debt.
The fact is that the size of your debt isn’t particularly determined by the actual dollar amount of debt that you have but by the impact that your debt has on your other finances. Today’s blog looks at how your debt influences not only your credit score but how you appear to lenders when you’re looking for new loans. Enjoy.
Payment history is vital.
The number one rule when it comes to debt is that you must be able to repay it with little difficulty. If you always pay bills on time your credit score should remain relatively high because, when it comes to calculating your score, payment history is the most important factor. A large amount of debt, in most cases, won’t negatively affect your credit score if you are paying all of your bills on time, all the time.
Credit utilization is important.
Let’s say that you have a credit card with a $2000 limit and every month, even though you repay your balance in full, you use $1000. What that equals is a 50% debt-to-credit ratio, and that’s much too high. The amount of debt that you use, called “credit utilization”, is almost as important a factor as payment history. VantageScore, for example, recommends that you don’t use more than 30% of your available credit at any one time.
If you’re keen on seeing what you’re VantageScore is, as well as your credit score on the “Big 3” credit reporting agencies, you’re eligible for a free credit report once a year and it’s recommended that you take advantage of this fact and get your credit report at least once a year to see how you’re doing.
Arnold Sprauve, a senior consumer credit specialist at FICO, advises consumers to “look at it in terms of your available credit, not just the raw numbers.” He believes that 30% is a good threshold but that consumers should strive to keep that number even lower. He also advises that, if you’re carrying a balance and don’t pay your credit cards in full every month, using a “rewards” card is a bad idea because the interest on those types of cards is usually higher, they encourage overspending and any gains that you might make from your so-called “rewards” probably won’t make up for the amount of extra money you pay in interest.
Two types of debt to income ratio.
Most experts recommend that you keep your “front end” debt-to-income ratio below 28%. This refers to the amount of money that goes to your existing loans use before any pretax income. Your “back-end” debt to income ratio, including mortgage payments, taxes and insurance, should be kept at 36% or lower.
In the end there are a lot of different components that make up your credit report and, while the actual amount of debt that you have certainly matters to an extent, every person’s situation is different. How much your debt affects your personal financial situation, and whether or not you can comfortably afford to repay that debt, is usually more important than the actual numbers themselves.