When people want to know how to manage their debt to increase their credit score, they often get stuck determining which kinds of debt impact their credit score the most. In reality, there are three kinds of debt: installment, revolving and open:
* Installment debt – A predetermined amount of debt to be paid off in equal amounts over a given period of time (for instance, leasing a car for $300 for 48 months). Each installment must be paid at the full, predetermined amount. The most common examples are mortgages and auto loans.
* Revolving debt –A debt in which the balance varies each month, and any unpaid amount is rolled over into the next month’s bill. The most common example is credit card debts.
* Open debt – Like a revolving debt, an open debt is based on a varying balance each month. These debts must be paid in full each month. Examples include cell phone, gas and electric bills.
Installment and open debts and your score
For installment debts, the amount you owe never changes. For open debts, you are in debt for a very short time. Since you will only be allowed to take out a predetermined or small amount, for these debts, the main influence on your credit score is whether or not you make your payments on time.
Revolving debt and Revolving Utilization
For revolving debts, the amount of debt you take out varies more than any other kind of debt, as does your balance after payments. Most people don’t pay off credit cards debts in full, and credit companies don’t expect you to do so. Instead, the credit bureaus have come up with the Revolving Utilization formula. To calculate this formula:
1. Add up the total credit limits of all your revolving debts
2. Add up the total balances remaining on these debts
3. Divide total balances by total credit limits
For example: Imagine you have one credit card with a $5000 limit that you owe $1500 dollars, and another with a $10,000 limit that you owe $3500. Your Revolving Utilization would be: $5000 ($1500 + $3500) / $15,000 ($5000 + $10,000), or 33.3%.
How this affects your credit score
Here are a few principles to keep in mind when considering the different types of debt:
Keep your revolving balances low – 30% of your credit score is determined by your Revolving Utilization ratio. While your credit limit will rarely change, the best way to keep this ratio low is to keep your credit card balances low in respect to the limit. You want to aim for keeping balances at 25% of the limit, and try to at least keep it below 50%.
Increase credit limits when possible – If you establish a good history of paying bills on time and keeping your balances low, credit card companies will be more likely to reward you with higher credit limits. This will lower your Revolving Utilization, and give a boost to your credit score.
Do NOT close unused accounts – It may make sense to cancel a credit card you no longer use frequently. However, doing so will almost certainly throw off your Revolving Utilization ratio, and can seriously hurt your credit score.
Don’t let creditors close unused accounts either – Credit card companies lose money off unused accounts, and will eventually close an account themselves if the period of inactivity is long enough. Make sure to charge something to all your accounts at least once a month. Ideally, you’d charge the card with the highest interest rate the least, and pay that debt off in full.
Related posts:
- What is a credit score?
- Credit Score Models
- Ten Things That Damage Your Credit Score
- What is a Foreclosure?
- Coping with Being Denied for a Loan
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