Understanding debt & credit scores (2024)

Understanding debt is critical to financial well-being. The decisions you make about when and how to borrow money can impact your finances for a long time.

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Bad debtis when you use credit cards to purchase disposable items or durable goods and don’t pay off the balance in full.

A common example of creating bad debt is using a credit card to purchase clothes. Clothes are typically worth less than 50% of what you pay for them when you walk out of the store. Each month that you make only a partial payment on your credit account, you are charged interest. The disposable or durable item you purchased continues to lose value, and the amount you paid for it continues to increase. You will ultimately end up spending more than the cost of the goods purchased by the time you pay off your credit card.Opening retail store credit cards to purchase clothes is even worse, as these credit cards come with high interest rates along with credit inquiries that negatively impact your credit score.

To see exactly what you might be paying for your purchases over time, use thisminimum payment calculatorto determine the real cost of paying only the minimum payment on credit card.

Good debtis investment debt that creates value. Medical education loans, real estate loans, home mortgages and business loans are all examples of good debt. Additionally, taking on debts that are tax-deductible and debts that produce more wealth in the long run are also good debts.

In some cases, taking out debt with a lower interest rate to pay off a debt with a higher interest rate can be a beneficial use of financing. As a rule, financing for something that is considered good debt usually has a lower interest rate than financing for something that is considered bad debt.

Credit cards

Credit cards

Credit cards have many benefits. Most significantly, they enable us to have what we want now and let us pay for it later. In fact, credit cards provide interest-free debt for up to 45 days from the date of purchase, depending on when in your billing cycle your purchase is made.

If you carry a balance from month to month, the interest rate charged on that balance is one of the key factors to consider in choosing a credit card. Experts suggest that a low, fixed-rate credit card is better than a low, variable-rate credit card. Card companies can raise their fixed-rate cards when interest rates go higher, but they need to give you notice. With a variable-rate card, your rate can move regularly and without any prior notification.

It is also critical not to miss payments on a credit card, even if you are only paying the minimum. If no payment is made within 30 days of the payment due date, credit card companies may report that to the credit bureaus.

When choosing a credit card, remember to pay attention to the annual percentage rate (APR), annual fee, grace period, penalties, late payment charges, over-the-limit fees, interest rates on any cash advances, and under what circ*mstances the card company can change your interest rate.

Credit scores

Credit scores

Acredit scoreis a number calculated based on your credit history. This number helps lenders identify how much risk they may be taking in lending you money and your odds of successful repayment. In addition to banks and lenders, landlords, merchants, employers and insurance companies may use a person’s credit score in their application or approval process.

The credit score most commonly used by lenders is known as aFICO score. Each of the 3 national credit bureaus, Equifax, Experian and TransUnion, has their own version of the FICO score. Some lenders also have their own scoring methods. Using online services likeannualcreditreport.com, you can request a free copy of your credit report or your credit score.

How credit scores are determined

How credit scores are determined

The credit scoring system awards points based on information in the credit report. The resulting score is compared to that of other consumers with similar profiles. With this information, lenders assess how likely someone is to repay a loan and make payments on time. A high credit score makes it possible to get instant credit at places like electronics stores and department stores.

Credit scoring methods may include information such as your income or how long you’ve been at the same job. A credit score can range from 300 to 900, with higher numbers indicating a better score.

  • Approximately 35% of the score is based on payment history.
  • Approximately 30% of the score is based onoutstanding debt. A good guide is to keep your credit card balances at 25% or less of their credit limits.
  • Approximately 15% of the score is based on the length of time credit has existed. The longer you’ve had established credit, the better it is for your overall credit score.
  • Approximately 10% of the score is based on the number of credit inquiries a person has received. Multiple inquiries could indicate that you are taking on a lot of debt. FICO scores only count inquiries from the past year.
  • The remainder of the score is based on current types of credit you have. The number of loans and available credit from credit cards you have makes a difference.

Increasing your credit score

Increasing your credit score

Since your credit score is based on your current credit report, your score changes every time your credit report changes.

Financial advisors often offer these tips for increasing your credit score:

  • Reduce the balances on any open credit cards.
  • Pay your bills on time—this will affect your credit score the most.
  • Review your credit report and correct any errors you find. Getting rid of inaccurate information can sometimes improve your score dramatically.
  • Request a credit increase to maintain your debt-to-credit ratio.
  • Don’t close all old accounts—this would unfavorably raise your debt-to-credit ratio.
  • Minimize the number of inquiries to your credit report.
  • If you are turned down for credit because of your score, review your credit report so you can make improvements.

Disclaimer: This information is provided for informational purposes only and should not be construed as financial or investment advice. Consult a professional regarding your specific situation.

external resources

Free Annual Credit Report

Access free annual credit reports from Experian, Equifax and TransUnion.

Table of Contents

  1. What is bad debt?
  2. What is good debt?
  3. Credit cards
  4. Credit scores
  5. How credit scores are determined
  6. Increasing your credit score
Understanding debt & credit scores (2024)

FAQs

How do you understand debt and credit? ›

Credit is the loan that your lender provides to you. It is the money you borrow up to the limit the lender sets. That is the maximum amount you can borrow. Debt is the amount you owe and must pay back with interest and all fees.

Can you be in debt and have a good credit score? ›

Having a mix of credit helps your credit score

The most creditworthy consumers don't have high scores because they are in debt; rather, it's because they likely have a variety of different credit products, such as credit cards and installment loans like a mortgage, that add up.

How do you understand by debt and credit services? ›

Credit allows individuals to receive goods and services now while agreeing to repay the amount borrowed plus interest at a later date. Debt refers specifically to the amount owed. 2. Consumer credit has played an important role historically by enabling consumers to purchase goods immediately and pay for them over time.

What is the best definition of a credit score in EverFi? ›

-A numerical rating of your credit-worthiness (how likely you are to pay off your debts).

What is the basic understanding of debt? ›

What is debt? Debt is something (usually money) borrowed by one party from another. Debt is used by both individuals and businesses to make purchases they couldn't otherwise afford, and gives them permission to borrow money under the condition it is paid back at a later date.

How do you analyze debt? ›

Here are some ways to analyze the ability of a company to manage its debt:
  1. Interest Coverage Ratio or Times Interest Earned. ...
  2. Fixed Charge Coverage. ...
  3. Debt Ratio. ...
  4. Debt to Equity (D/E) Ratio. ...
  5. Debt to Tangible Net Worth Ratio. ...
  6. Operating Cash Flows to Total Debt Ratio.
Jun 21, 2023

What does your credit score indicate? ›

A credit score is a prediction of your credit behavior, such as how likely you are to pay a loan back on time, based on information from your credit reports.

Is debt the only factor in credit score? ›

Approximately 35% of the score is based on payment history. Approximately 30% of the score is based on outstanding debt. A good guide is to keep your credit card balances at 25% or less of their credit limits. Approximately 15% of the score is based on the length of time credit has existed.

What is a good debt? ›

Debt that helps put you in a better position may be considered "good debt." Borrowing to invest in a small business, education, or real estate is generally considered “good debt” because you're investing the money you borrow in an asset that will improve your overall financial situation.

What habit lowers your credit score? ›

Having Your Credit Limit Lowered

Recurring late or missed payments, excessive credit utilization or not using a credit card for a long time could prompt your credit card company to lower your credit limit. This may hurt your credit score by increasing your credit utilization.

What's a good credit score? ›

A good credit score is generally 690 to 719 on the 300-850 scale commonly used for FICO scores and VantageScores. Amanda Barroso is a personal finance writer who joined NerdWallet in 2021, covering credit scoring.

Which credit score should I rely on? ›

FICO scores are generally known to be the most widely used by lenders. But the credit-scoring model used may vary by lender. While FICO Score 8 is the most common, mortgage lenders might use FICO Score 2, 4 or 5.

How do you understand debit and credit in accounting? ›

The basics of DR and CR

The individual entries on a balance sheet are referred to as debits and credits. Debits (often represented as DR) record incoming money, while credits (CR) record outgoing money. How these show up on your balance sheet depends on the type of account they correspond to.

Does credit mean I owe money? ›

A credit can happen for many reasons. It means you've paid more than your usage to a supplier – so they owe you money. Or you're choosing to build up your credit balance to spread the cost across the year.

How do you explain debt? ›

Debt is money you owe a person or a business. It's when you've borrowed money you'll need to pay back. Usually, people borrow money when they don't have enough to pay for something they want or need.

What is an example of credit vs debt? ›

Debt is amount of money you owe, while credit is the amount of money you have available to you to borrow. For example, unless you have maxed out your credit cards, your debt is less than your credit.

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