How to Manage Debt and Improve Your Credit Score

Managing debt effectively is crucial for maintaining a healthy credit score. If you don’t manage your debt wisely, your credit score can decrease due to late payments, high total balances, high credit utilization, and too many applications for new credit. On the flip side, strategically using a credit card and taking on manageable installment debt can improve your credit. It’s important to strike a balance between using debt to your advantage while preventing it from getting out of hand.

How Does Debt Affect Your Credit Score?

When you have a lot of outstanding debt relative to your credit limit or a history of late payments, that signals to credit scoring models and creditors that you’ve had difficulty managing debt in the past and that you may have trouble paying back debt in the future. As a result, you may receive a fair or poor credit score, which will make it harder to successfully apply for new credit and likely result in higher annual percentage rates (APRs) for any credit you do get.

However, there is some nuance to how debt affects your credit score. Merely using a credit card or taking out a loan isn’t a red flag. In fact, having a healthy credit mix—a range of revolving credit like credit cards and installment credit like loans—can help your credit score. Adding positive payment history from credit card or loan accounts to your credit report can also improve your credit.

It’s important to only take out loans you know you can pay back on time each month. Also, keep your credit utilization rate—or the percentage of revolving credit limit you’re using on each credit card, and overall—as low as possible. Those with the highest FICO® Scores have a credit utilization rate of about 7%, according to Experian data from the third quarter of 2023.

Good Debt vs. Bad Debt

Some debt is more likely to have a positive effect on your long-term financial strength. Common examples of “good debt”—if they come with affordable monthly payments that you pay on time—are a mortgage, a car loan, and federal student loans. These types of debt can provide, respectively, the ability to build wealth, get to work reliably, and widen your skill set.

“Bad debt,” on the other hand, is any kind of debt that gets out of hand, comes with particularly high interest rates, and doesn’t fit within your budget. Credit card debt that leads to high credit utilization rates and ongoing balances is an example of bad debt. So are payday loans and car title loans, which can have effective APRs of 300% or more.

How to Manage Debt

Taking on debt doesn’t have to lead to a lower credit score. Quite the opposite: Using a credit card judiciously and making regular payments toward installment loans will likely strengthen credit. Here’s how to make sure debt works in your favor.

Set up Autopay

For all credit card or loan accounts, pay your bills on time, every time. On your lender’s or issuer’s website, set up automatic payments from a bank account each month. Ideally, for credit cards, set up autopay so that you pay your whole outstanding balance. Throughout the month, make sure you have enough cash in your connected bank account to prevent an overdraft.

Pay Off Credit Cards Each Month

To keep credit card debt under control, aim to use less than 30% of your credit limit at all times, but lower is better. An ideal goal could be to use 10% or less of your credit limit on each card and across all of your credit cards to ensure the best possible effect on your credit score. To ensure you don’t carry debt from month to month, incurring interest charges and making your balances grow, pay off your outstanding balance every billing cycle.

Seek Help Before You Miss a Payment

Your finances may fluctuate, and if there’s a possibility that you could miss a loan or credit card payment, take action and call your lender or issuer beforehand. Your mortgage lender may offer a temporary pause to your bills, called a forbearance; the credit card company may have a hardship plan. It’s always better to reach out and ask than to risk a late payment, which can hurt your credit score.

How to Improve Your Credit Score

To further improve your credit, consider taking the following steps:

Apply for a Secured Credit Card

A secured card is a credit-building tool that functions like a traditional credit card. The difference is that it requires a refundable cash security deposit that often becomes the card’s credit limit. It’s a strong option for those new to credit, or eager to build it, who want to learn how to manage debt.

Apply for a Credit-Builder Loan

This is another option for building credit, but in the form of an installment loan. As you make payments toward a credit-builder loan, those payments will appear on your credit report, and the balance will be available to you—minus fees and interest—as a savings account at the end of the loan term.

Avoid Closing Your Oldest Credit Card

Even if you no longer have use for your oldest card, its age can benefit your credit score, especially if you don’t have many other credit card or loan accounts. Rather than closing a credit card, consider using the card for a small recurring purchase or asking the issuer to switch your account to a different card you’d be more likely to use.

Limit New Credit Applications

While opting for a secured credit card or credit-builder loan could improve your credit, taking on more credit cards or loans than you can handle will put you at risk of missed or late payments. Plus, too many applications for new credit can negatively impact your credit score.

Frequently Asked Questions

Should I Pay off My Credit Card Balance in Full or Over Time?

Paying off your credit card balance in full each month is generally the best approach. It helps you avoid interest charges and keeps your credit utilization low, which can positively impact your credit score.

Why Does My Credit Score Go Down When I Pay Off Debt?

Your credit score might temporarily dip when you pay off debt because it changes your credit utilization and credit mix. However, in the long run, paying off debt is beneficial for your credit score.

What Is a Good Credit Score?

A good credit score typically ranges from 670 to 739. Scores above 740 are considered very good to excellent, while scores below 670 may need improvement.

The Bottom Line

Managing your debt strategically is crucial in order to maintain good credit. Keep credit card balances low throughout the month, pay off your total balance at the end of every month, and only take out loans that you need and can pay off as agreed. You can also take additional steps to let your debt work for you by ensuring you have a solid credit mix and that you keep your oldest credit card accounts open, if possible. Your credit score is an important part of your financial life; dealing with debt wisely is an effective way to keep it strong.

For any mortgage service needs, call O1ne Mortgage at 213-732-3074. Our team is here to help you navigate your financial journey and achieve your homeownership dreams.