From a credit standpoint, the type of debt you’re carrying matters tremendously when it comes to your credit score and your overall credit rating. What precisely counts as “bad” debt? Nearly 100% of the time, it’s credit card debt.
Yes, if the balances on your Visa, MasterCard, American Express or Discover cards have gotten out of control, you’re likely doing some serious damage to your credit. But other types of debt aren’t good for your credit rating either – like department store charge card you opened just to get 10% off your purchase, or the retail credit account you got to buy household furniture. Don’t feel bad if this describes you. I’ve made the same mistakes.
Your Credit Score is Largely Based on How Much Credit Card Debt You Carry
Your FICO score is strongly tied to the credit card debt you have, and that includes national brand cards, like Visa or MasterCard, and charge cards too. In fact, according to Fair Isaac (creator of the FICO credit score), 30% of your credit score is based on the amount debt you have. Do you think that pertains to your mortgage debt or student loans? Although those debts are examined in other ways during FICO’s calculation, the debt FICO is overwhelmingly concerned with is your credit card debt. Let me explain why.
Your Mortgage Debt Helps Your Credit Rating – As Long as You Pay on Time
The FICO scoring system evaluates three forms of debt in your credit files:
- mortgage debt
- installment debt
- revolving debt
Mortgage debt is very straightforward. This is the house note you have on your primary residence, the home equity loan or home equity line or credit you may have, or perhaps the mortgage you pay if you’re lucky enough to have a vacation home or investment property. In short, if you own a piece real estate, and you have a loan for which the house is collateral, you have some form of mortgage debt. Generally speaking, this is the most highly-rated form of debt in the FICO scoring system.
Installment Debt Includes Car Loans and Student Loans
Next up is installment debt. This refers to one-time loans you took out that you are paying off over time, by making fixed payments at regularly scheduled intervals. For instance, assume you received a $10,000 student loan five years ago and you are now repaying the loan. You may be making $125 payments every month, due on the 15th of the month. In this case, your student loan balance does one thing: it declines every month. Part of your $125 a month payment goes toward knocking down the principle balance and part of it goes toward paying interest on the loan. The same deal applies with car loans.
Let’s say two years ago you bought a $35,000 automobile and you still have three years worth of payments until you own the car free and clear. You car note might be $400 a month, and it’s due on the 3rd of every month. So each month you send a check, or maybe you use automatic deduction from your checking account, to make your timely payments to the auto finance company. Once again, both you and the lender know that your auto balance is only heading in one direction: down.
Those car payments you are making are steadily chipping away at your auto debt. In both instances, with your student loan and your auto loan, the lender knows exactly what their risk is at any given time. It’s the outstanding balance on your loan. But the lenders also know that your balance isn’t going to rise. Thus, installment loans are “good” forms of debt, from a credit-scoring standpoint. They are unlikely to hurt your credit ranking, as long as you pay on time.
Revolving Debt, or Credit Card Debt, Can Hurt Your Credit Scores Greatly
The last category, however, revolving debt, represents a potential minefield for lenders – and you – in many ways. Revolving debt, such as credit cards, is the riskiest form of debt from a lender’s standpoint, because the lender has far less control over this debt, and you call the shots on it in many ways. Assume, for a moment, that you have a MasterCard with a $5,000 credit limit.
Your balance this month might be $1,900. But last month the balance was $1,255, and the month before that it was $1,641. As it stands, neither the lender nor FICO has any way of knowing how much you’re going to charge in any given month. They can try to predict it – and they do try, as you’ll learn later. But for the most part, they can’t know with certainty whether you will charge $30, $300 or even $3,000 on your card in the following month.
Why Credit Card Debt is a Wild Card When It Comes to Credit Scoring
There is another reason why revolving debt isn’t scored favorably in the FICO scoring model: No one knows exactly how much you will pay on your credit card balance. You might decide to make minimum payments, you may opt to pay $500 toward the overall balance, or you may feel flush with cash and decide to pay off the entire balance outstanding.
Whatever the case, the amount of the payment is pretty much up to you, provided you at least make the minimum required payment. But that’s not much, since most banks and credit card issuers only require that you pay about 4% of the outstanding balance in any given month. This means on that card with a $1,900 balance, your minimum payment would be just $76.
The bank’s exposure is still $1,824. That’s the amount of money at risk for them if you don’t pay up for any reason. Moreover, if you fail to pay that credit card balance due is no longer a “risk-weighted asset.” It swings over to the “non-performing” asset section of the bank’s balance sheet.
Extending credit via credit cards can be a high-stakes enterprise. When a bank approves your credit card application, they’re basically agreeing to let you take out a loan, by making purchases on the credit card. Issuing that credit card can be far riskier than making a loan to someone buying a car, because in the latter case the bank knows exactly how much the monthly payments will be and they know the balance on that auto loan will never rise. Neither of those things is true when it comes to credit cards.
The Difference Between Secured and Unsecured Debt
Speaking of cars, there is one final noteworthy comparison between installment loans, such as auto loans, and revolving debt, like credit cards, that demonstrates why revolving debt is deemed riskier. A car loan is a secured loan. If you don’t pay what you owe, the lender can come to your house and repossess the vehicle. (And don’t even think about trying to hide it around the block when your payment is past due. I tried that many years ago while I was in college, but the repo man still found my Hyundai Excel and hauled it away. While I have excellent credit now, I had awful credit in my past. But I digress…)
A credit card, in contrast to a car loan, is an unsecured form of debt. If you charge $800 on your Visa card for that flat-screen TV you just had to have, what is the bank going to do if you don’t pay your credit card bill? They can’t come in your house and snatch that 40-inch TV off the wall. So they’re mainly stuck with reporting you to the credit bureaus if your payment is 30 days or more late.
Of course, your account could go into collections, or they could get a judgment against you if they felt it was worth the time and money to go those routes. But the central concept you need to understand is that secured loans – whether it’s on real estate or automobiles or something else – are always less risky to lenders than are unsecured debt, like credit cards. As a result, that unsecured debt filling your credit report, courtesy of those credit cards in your wallet, will always get judged more severely in the credit scoring world.
Not All Debt is Created Equally
In summary, not all debt is created equally. Credit card debt is the form of debt most closely watched by the credit industry because it’s unsecured debt; it’s largely controlled by your choice of payments and spending; plus, credit cards are more frequently used than other forms of debt, thereby providing more insights into your overall financial habits.
Excerpt from Perfect Credit: 7 Steps to a Great Credit Rating