Good Debt Vs. Bad Debt: What Each Does to Your Credit

man checking his credit score on an iPad

The Value Getting Relief From Debt

Every day, millions of Americans grapple with financial woes. Households in this country owe more than $13 trillion in overall debt, per a 2017 study, and, as of March 2018, the average home that carries debt owes more than $130,000. The latest information from the U.S. Census Bureau states that the median household income is only $59,039. Put all these numbers together, and it is clear many Americans are living beyond their means, especially when it comes to their unsecured debt.

If you are trying to get a grip on your finances and receive relief from debt situations, you may be presented with some difficult questions. Should you consider a settlement? What kind of relief is possible? How bad does debt consolidation hurt your credit score?

Certainly, there are a lot of different strategies worth exploring. Before you do so, however, you need to understand a few key concepts. One is the difference between good debt and bad debt.

Good Debt (Yes, It Does Exist)

The term “good debt” may seem like an oxymoron, but it does make sense. In essence, a good debt is any financial obligation that can improve your life. A mortgage can be considered a good debt because it gives you a place to live and, with some luck and shrewd management, can appreciate in value.

Student loans fit the bill, as well. Although adults throughout the country are struggling to make these payments—Americans owe nearly $1.5 trillion in student loan debt—a good education can lead to many professional opportunities and a higher income. Additionally, if you take on a loan to start your own business, that qualifies as good debt, because, if all goes according to plan, it will pay for itself—and then some.

The Fact About Bad Debt

Bad debt, on the other hand, comes from any kind of item that becomes less valuable the second you buy it. Credit cards, for example, are a common cause of bad debt. The vast majority of credit card purchases are paid off with interest rates included. That means, over time, you will pay above and beyond the original price. Payday loans, car loans, and furniture loans fit into this category, too. All this makes getting relief from debt a complex process.

wallet full of credit cards on a table

Your Credit Score

As it turns out, good debt tends to affect your credit score in a different way than bad debt. Before getting to that distinction, though, let’s take a look at how important debt is to your credit score in general.

Whether you are getting your credit score from Equifax, Experian, or TransUnion—the United States’ three credit bureaus—debt will play a big factor. Overall, debt accounts for 30 percent of your credit score. It is understandable why that figure is so high: Debt level helps lenders understand how risky a consumer is compared to the rest of the population.

Revolving and Installment Debts

It would be nice if all relief from debt immediately affected your credit score positively, especially if it’s relief from bad debt. Truth is, when it comes to your credit score, the more important distinction to make is not one between good or bad debt but is instead the one between revolving debt and installment debts. Credit bureaus like to see a mix of the two, but they are different in many ways.

Revolving Debt: This is easy to obtain, and it is easy to misuse. It is composed of open-ended accounts and usually has variable interest rates and predetermined credit limits. Credit cards and credit lines are common types of revolving debt.

When you are dealing with a revolving debt, you do not have to pay a certain amount each month. Specific loan terms are not required, either, and you can borrow money as you feel the need, provided you do not reach your credit limit. Typically, these loans do not have an end date; if you make the minimum payments each month, along with the necessary fees, it can remain open.

Installment Debt: Conversely, installment debts are paid in fixed amounts over a rigid period of time. Ordinarily, these obligations come with a fixed interest rate, too, so when the loan is agreed upon, the borrower will know exactly how much he or she will have to pay, and exactly when the loan will end.

Usually, but not always, good debts come in the form of installment credit, as mortgages, student loans, and private personal loans tend to fall into this category. Given how expensive these obligations can be, borrowers want to pay fixed interest rates on them. It is not advisable to take out a mortgage or a five-figure university loan if the interest rate can increase over time.

Debt and Credit Score

Being responsible with an installment loan is a great way to improve your credit. While your score may dip right after the loan begins, that should quickly change as long as you send in the compulsory payments when they are due. Indeed, people who make all of their payments over a years-long span show they are reliable borrowers, and, as a result, see their scores move in the right direction.

Unsurprisingly, revolving debts are the source of most efforts to gain relief from debt. That is because a big part of your credit score is determined by how much you owe compared to your available credit. This is known as the credit utilization ratio. If you are using more than 30 percent of your available credit, you should expect to be penalized in the form of a lowered score.

With installment debts, credit utilization ratio is not a big concern, as you know all of the specifics involved. But when it comes to credit cards, you need to monitor how much available credit you are using. You should avoid going above the 30 percent threshold whenever possible.

Receive Debt Relief Today

In most instances, relief from debt can reduce your credit score. As Americans try to accomplish this, they often ask how bad does debt consolidation hurt your credit score, and while the answer varies from case to case, it is usually substantial.

stamping checkbook

There are better ways to deal with unsecured debt than consolidation. At Liberty Debt Relief, we can provide the answers you seek, and we can provide a clear path forward.

If you are ready to receive a free consultation and learn how we can offer effective relief from debt, reach out to us today.

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