Road to Better Credit: Understanding the impact of debt on credit ratings
Welcome back to the Road to Better Credit. In this post, the third of four parts, we’ll help you understand the ways debt affects your credit rating, and provide you with tips to help get out of debt.
Several factors shape our attitudes towards debt and credit use, not the least of which is the approach our parents took to teaching children about money. As we begin to make our own financial choices, whether or not to go into debt to make a purchase is an important decision. Knowing the difference between good debt and bad debt may help to influence that decision.
What is good debt?
Personal feelings and family attitudes toward debt aside, some debts are better than others. Generally speaking, good debt is an “investment in something that creates value or produces more wealth in the long run.” Good debt can include mortgages, student loans and business loans. On the other hand, bad debt is typically categorized as borrowing for purchases that are immediately consumed or go down in value, like unnecessary consumer purchases. Keeping the different types of debt in mind can help you to focus your efforts.
While the advice to get out of debt applies to both good and bad debt, the focus should generally be to pay off debt with the highest interest rate first.
The effects of debt on credit applications
Paying off debt will reduce the amount of interest you have to pay. It may also help improve the chances that a future credit application will be approved, especially if most of your accounts are at or near the credit limit. According to Equifax Canada, a consumer credit reporting agency, lenders prefer to see a lower debt to credit ratio, i.e., that the amount of credit you are using is low relative to the total amount available to you.
Get out of debt
The long-term impact of paying off debt can outweigh the short-term discomfort of the sacrifices you may need to make. However, as we shared in a previous post, you will have a better chance of achieving your goal of getting out of debt if you take the time to make a carefully considered plan.
For example, suppose you have multiple outstanding balances to pay off. In that case, you might consider starting with your highest-interest debt first and then consolidating debt to a lower interest card when you have the available credit capacity.
Learn more strategies to help you manage credit by reading the other posts in our “Road to Better Credit” series: Understanding credit scores and Avoid applying for too much credit, and visit our website to learn more about the consolidation options that may be available to help you pay off debt.
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