Last updated on August 24th, 2023
Understanding how credit card debt may affect your credit score may give you the confidence you need to manage your finances. Here are three ways your credit card debt impacts your credit scores.
Credit Card Debt and Its Effects on Credit Scores
Credit card debt in the US is on the rise and closing in on $1 trillion – exactly $986 billion in the first quarter of 2023. It is the first time since 2001 in which credit card debt didn’t dip in the first quarter. It’s no secret that credit card debt is affecting the nation, especially during times of inflation. However, American pockets are not the only thing credit card debt can affect, it can also impact credit scores.
The makeup of credit scores varies on the scoring model used for each credit report. The two most used credit scoring companies by lenders are FICO and VantageScore®. The more popular type of credit score is the FICO score, and it is calculated on multiple scoring models. FICO scores typically range from 300 to 850 – the higher the score the better your credit report. Numerous factors affect your FICO score.
How FICO Credit Works?
Numerous factors affect your FICO score. The credit data that builds your FICO score is gathered by the three main credit bureaus: Experian, TransUnion, and Equifax. A FICO credit score is determined by analyzing five pieces of data. The data categories include payment history (35%), amounts owed (30%), length of credit history (15%), credit mix (10%), and new credit (10%).
The Effects of Not Paying Your Debt
Credit card debt impacts your credit score if not paid on time. Missing or late payments past grace periods can have a negative effect as its reporting accounts for 35% of your FICO score. On the extreme side, not paying your credit card debt will cause you to default, resulting in turning over your account to collections.
Your credit card payment history is a crucial indicator to lenders about your money management habits and how you might handle future payments. It is possibly the most influential factor to monitor. Set automatic payments or reminders to stay on track with all your credit card payments.
Credit Card Debt Impacts Credit Utilization
Notice that the amount owed category in your FICO credit score counts towards a large chunk – precisely 30%. As a result, credit card debt rolls in and affects your credit score. This part of your credit score can also be described as your credit utilization ratio. The credit utilization ratio calculates what percentage of your credit limits is used up by credit card debt.
It is recommended by experts to keep credit utilization under 30%. You can calculate your credit utilization ratio by adding up all your credit card balances (credit card debt), then add up your credit cards’ credit limits. Calculate what percentage of your debt is taking up your total credit limit.
If your calculations show your credit card debt makes up more than 30% of your credit limits, then chances are your credit score is taking a significant hit from your debt. Additionally, maxing out a credit card is not a good look to lenders as it signals the applicant may be overextending themselves, therefore considered a high-risk.
Do Balance Transfers Hurt Your Credit Score?
Credit card balance transfers can benefit anyone looking to quickly chip away at credit card debt and save money on interest. However, the credit card debt you transfer can have a minor negative effect on your credit score. Firstly, if you do a credit card balance transfer and close out the original existing account, your score might drop for two reasons.
The first reason is that it affects the length of your credit history, which accounts for 15% of your FICO score. This doesn’t mean you should never close out an old account. If you have too many credit card accounts open and you’re working on your credit, it’s okay to close accounts and get organized. Everyone’s credit journey is different.
Related Article: The Best Balance Transfer Credit Cards
The second reason closing out an existing credit card account may not always be helpful to your score is that it may affect your credit utilization. For example, say you have a credit card with a $9,000 credit limit and a $7,000 balance. You may choose to do a balance transfer to benefit from better rates and 0% intro APR offers. If the new balance transfer credit card has an exact $7,000 credit limit, your overall available credit will reflect a maxed-out credit card. Additionally, you have now lowered your total credit limit, which will result in a higher credit utilization ratio.
Lastly, your credit score might take a dip in the transition phase of your credit card balance transfer. Your old credit card balance may reflect on your report concurrent with your balance transfer. Therefore, showing two different credit lines with high balances. For example, a $7,000 balance might turn into double ($14k) during the balance transfer transition. This is a minor concern because the next month should reflect the original balance as current.
Related Article: Paying Off Debt – Debt Avalanche vs Debt Snowball
Featured image by alexsl/Getty Images Signature