A good credit score is the gateway to better borrowing. With a strong credit profile, you can qualify for more lending products with lower interest rates. So how do you improve your credit score? By eliminating debt.
Your credit score tells lenders how risky it is to lend you money. The higher your score, the safer it is to lend to you, and the more likely you’ll qualify for loans at the best interest rates on the market. Yet, if you’re carrying a lot of debt, your credit score is suffering—even if you’re making all your payments. A clean credit score is not synonymous with a good one. Credit bureaus look at more than just your payment history to determine your creditworthiness.
How does debt affect your credit score?
Credit bureaus use a number of factors to determine your credit score such as:
- Payment history
- Utilization rate
- Types of credit
- Recent inquiries into your credit history by others
Payment history has the largest impact on your credit score. Missing payments or making a late payment negatively affects your score, signaling that you may be stretched too thin. In addition, credit bureaus look at your utilization rate, which is the percentage of credit you’re using versus the credit available on that loan/credit card. Maxing out your credit cards, lines of credit, and loans tells credit bureaus that you could be reaching a financial breaking point. Ideally, your utilization rate should never exceed 30%.
Although not weighted as heavily as the previously mentioned factors, types of credit and inquiries into your credit history also affect your score. Carrying only one term loan (like a car loan) and several credit cards could alert credit bureaus that you’re not managing your credit wisely. In addition, every time you apply for loan or credit card, the lender asks the credit bureaus (Equifax and TransUnion) for a copy of your credit report. Several recent inquiries could trigger a credit bureau to label you a bad credit risk, especially if you’ve applied and reapplied for several loans in a short period of time.
Eliminate debt to improve your credit score
The most crucial step to rebuilding your credit score is to get out of debt. This means taking stock of how much you owe, making a budget, and setting a timeline of when you’d like to be out of debt.
There are two popular methods of tackling debt. You can either pay off the debts in order of the highest interest rates or in order of the smallest to biggest amounts owed. While tackling the debts with the highest interest rates first will help you get out of debt faster and save money on interest, both methods are good strategies for becoming debt free.
However, if you discover it’ll take several years to pay off your debts, it may be time to speak with a licensed insolvency trustee. They can review your financial situation, walk you through your options, and make recommendations, such as a consumer proposal or personal bankruptcy.
While your credit score will initially fall as a result of a consumer proposal or bankruptcy, eliminating your debts is the first step to rebuilding your credit. If you’re missing payments, receiving collection calls, or being denied more credit, chances are you’ve already been labelled a bad credit risk and your credit score is suffering. And it will continue to suffer if you delay dealing with your debts.
Instead, create a healthy financial profile by getting out of debt. Once you’re no longer burdened with debt, you’ll be able to start rebuilding your credit score by getting a secured credit card and managing your credit wisely. Speak with a licensed insolvency trustee to learn more about how to rebuild your credit by getting out of debt. The first consultation is always free.
- What’s a Bankruptcy Score and How Does It Affect Your Creditworthiness?
- What to do if You Want to be Debt Free
- Credit Card Debt Relief in Canada: What Are Your Options?
Flickr: Simon Nowak