In this article:
- How Does Debt Affect Your Credit Score?
- How to Manage Debt
- How to Improve Your Credit Score
If you don't manage your debt wisely, your credit score can decrease as a result of late payments, high total balances, high credit utilization and too many applications for new credit.
On the flip side, strategically using a credit card and taking on manageable installment debt can improve your credit. That means it's important to strike a balance between using debt to your advantage while preventing it from getting out of hand.
Here's how your credit can be affected if you don't manage debt thoughtfully.
How Does Debt Affect Your Credit Score?
When you have a lot of outstanding debt relative to your credit limit or a history of late payments, that signals to credit scoring models and creditors that you've had difficulty managing debt in the past and that you may have trouble paying back debt in the future.
As a result, you may receive a fair or poor credit score, which will make it harder to successfully apply for new credit and likely result in higher annual percentage rates (APRs) for any credit you do get. But there is some nuance to how debt affects your credit score. Merely using a credit card or taking out a loan isn't a red flag. In fact, having a healthy credit mix—a range of revolving credit like credit cards and installment credit like loans—can help your credit score. Adding positive payment history from credit card or loan accounts to your credit report can also improve your credit.
It's important to only take out loans you know you can pay back on time each month. Also, keep your credit utilization rate—or the percentage of revolving credit limit you're using on each credit card, and overall—as low as possible. Those with the highest FICO® Scores☉ have a credit utilization rate of about 7%, according to Experian data from the third quarter of 2023.
Good Debt vs. Bad Debt
Some debt is more likely to have a positive effect on your long-term financial strength. Common examples of "good debt"—if they come with affordable monthly payments that you pay on time—are a mortgage, a car loan and federal student loans. These types of debt can provide, respectively, the ability to build wealth, get to work reliably and widen your skill set.
"Bad debt," on the other hand, is any kind of debt that gets out of hand, comes with particularly high interest rates and doesn't fit within your budget. Credit card debt that leads to high credit utilization rates and ongoing balances is an example of bad debt. So are payday loans and car title loans, which can have effective APRs of 300% or more.
How to Manage Debt
Taking on debt doesn't have to lead to a lower credit score. Quite the opposite: Using a credit card judiciously and making regular payments toward installment loans will likely strengthen credit. Here's how to make sure debt works in your favor.
Set up Autopay
For all credit card or loan accounts, pay your bills on time, every time. On your lender's or issuer's website, set up automatic payments from a bank account each month. Ideally, for credit cards, set up autopay so that you pay your whole outstanding balance (more on that below). Throughout the month, make sure you have enough cash in your connected bank account to prevent an overdraft.
Pay Off Credit Cards Each Month
To keep credit card debt under control, aim to use less than 30% of your credit limit at all times, but lower is better. An ideal goal could be to use 10% or less of your credit limit on each card and across all of your credit cards to ensure the best possible effect on your credit score. To ensure you don't carry debt from month to month, incurring interest charges and making your balances grow, pay off your outstanding balance every billing cycle.
Seek Help Before You Miss a Payment
Your finances may fluctuate, and if there's a possibility that you could miss a loan or credit card payment, take action and call your lender or issuer beforehand. Your mortgage lender may offer a temporary pause to your bills, called a forbearance; the credit card company may have a hardship plan. It's always better to reach out and ask than to risk a late payment, which can hurt your credit score.
How to Improve Your Credit Score
To further improve your credit, consider taking the following steps:
- Apply for a secured credit card. A secured card is a credit-building tool that functions like a traditional credit card. The difference is that it requires a refundable cash security deposit that often becomes the card's credit limit. It's a strong option for those new to credit, or eager to build it, who want to learn how to manage debt.
- Apply for a credit-builder loan. This is another option for building credit, but in the form of an installment loan. As you make payments toward a credit-builder loan, those payments will appear on your credit report, and the balance will be available to you—minus fees and interest—as a savings account at the end of the loan term.
- Avoid closing your oldest credit card. Even if you no longer have use for your oldest card, its age can benefit your credit score, especially if you don't have many other credit card or loan accounts. Rather than closing a credit card, consider using the card for a small recurring purchase or asking the issuer to switch your account to a different card you'd be more likely to use.
- Limit new credit applications to what you really need. While opting for a secured credit card or credit-builder loan could improve your credit, taking on more credit cards or loans than you can handle will put you at risk of missed or late payments. Plus, too many applications for new credit can negatively impact your credit score.
Frequently Asked Questions
Ideally, you'll pay off your credit card balance in full in order to avoid interest charges and to prevent debt from growing. If you choose to use a balance transfer credit card at 0% introductory APR to pay off existing credit card debt, it makes sense to pay off that balance over time—but make sure it's gone by the end of the 0% APR promotional period.
When you pay off an installment loan, your score may go down temporarily if it was your one installment loan and you only have revolving credit left, since that reflects a more limited credit mix. Or your score may go down if all remaining accounts have high balances compared with their initial loan amounts or credit limits. Paying off a credit card could lead to a lower score if you close the card after bringing the balance to zero. It's often better to keep the card open but use it for just a single regular charge to prevent a drop in your score.
A good credit score is usually around 700 or above. In the FICO® Score model, a good credit score is between 670 and 739 on a 300- to 850-point scale. In the newest VantageScore® credit scoring models, good credit is between 661 and 780 in the same range.
The Bottom Line
Managing your debt strategically is crucial in order to maintain good credit. Keep credit card balances low throughout the month, pay off your total balance at the end of every month and only take out loans that you need and can pay off as agreed.
You can also take additional steps to let your debt work for you by ensuring you have a solid credit mix and that you keep your oldest credit card accounts open, if possible. Your credit score is an important part of your financial life; dealing with debt wisely is an effective way to keep it strong.
