Your credit scores are influenced solely by the information that appears on your credit reports. Many people assume that if they make their monthly payments on time, their credit scores will be just fine. That isn’t always true. Of course your payment history is an important factor, indeed the most important factor, that credit scoring models consider when calculating your credit scores. Still, credit scoring goes much deeper than just how you pay your bills.
Debts that take away from your net worth and don’t have much redeeming value are often considered bad, such as credit cards.
The debts that appear on your credit reports, especially the types of debts, are also relevant to the calculation of your credit scores. And, there is a big difference between your mortgage debt and your credit card debt where credit scores are concerned.
Type of Debt
All debt is not created equal. From a financial perspective, some debts are generally considered to be good debts while others are generally considered to be bad debts. Many financial advisors agree that debts that have the potential to increase your net worth may be considered good, such as mortgages and student loans. On the other hand, debts that take away from your net worth and don’t have much redeeming value are often considered bad, such as credit cards.
Credit scores don’t consider debts the same way. They care more about what’s empirically predictive of elevated credit risk, and nothing more. In the credit scoring world, not-so-bad debts would typically be classified as installment accounts, like mortgages, student loans and personal loans, and bad debts would typically be classified as plastic, like credit cards. Credit scoring models like FICO and VantageScore are designed to treat these two categories of debt very differently because one is highly predictive of elevated risk while the other is not.
Debt Type 1: Revolving
Credit cards are classified as revolving accounts. The balances on these accounts can potentially have a negative impact on your credit scores. The more debt you have, the worse that negative impact could become.
Nearly 30 percent of your credit score points are based upon your debt, and a large portion of that 30 percent is based on your revolving utilization ratios. Revolving utilization can be calculated by comparing the balances that appear on your credit card to your credit card limits. If your credit report shows that you have a $2,500 balance on a credit card with a $5,000 limit, your revolving utilization ratio on that account would be 50 percent.
Because consumers with higher revolving utilization ratios have been shown to be higher risk borrowers, as your revolving utilization ratio climbs your credit scores will likely decline. Simply put, the higher the percentage, the lower your scores. This can be true even if you keep all of your credit card payments on time. The solution: Maintain low balances.
Debt Type 2: Installment
Credit scoring models are designed to be much more forgiving of your installment debt. Why is that? Because installment debts are less predictive of elevated risk than credit card debt. In fact, you can carry a very large amount of installment debt, such as a mortgage loan, and the debt itself is likely to have very little negative impact on your credit scores.
This makes common sense as well as empirical sense. Installment debts, such as mortgages and auto loans, are generally secured by a physical asset like your house or your car. As a result, you are typically less likely to pay late or, worse, risk going into default on installment accounts. You don’t want to lose your home to foreclosure for non-payment and you don’t want to lose your car to repossession for non-payment.
Keep in mind: When you pay off installment debts, your scores are not going to fly through the roof. If the debt didn’t lower your score to begin with, paying it off isn’t going to improve your score. But, to the extent you won’t be paying interest on a home loan or auto loan any longer, that’s always a good thing.