Debt has a negative connotation for most people, but it's not all bad. In fact, you're better off having some debt on your credit report than none at all. A good payment history shows lenders that you can be responsible with borrowed money, and it will make them feel better about lending to you when the time comes for you to make a big purchase, like a home. If you have no previous debt repayment history, lenders are in the dark about how you will handle it. This indicates a greater risk, and they may charge you higher interest rates or deny you outright just to hedge their bets.
Having some debt is a good thing, provided you can comfortably afford to make your payments each month. But not all debt is the same. There are actually three different types, and having a mix of them will boost your credit score more than having just a single one. In fact, 10% of your FICO score is determined by the mix of credit accounts in your name.
Here's a brief overview of the three types of credit and how you can get them.
Revolving debts give you a line of credit that you can borrow up to each month. Credit cards are the most common type of revolving debt, and they're usually the most accessible form for most people. However, if you're a homeowner, a home equity line of credit (HELOC) is another type of revolving debt that may be available to you.
The main advantage of choosing revolving debt is its flexibility. You're allowed to spend up to your credit limit each month, but you don't have to if you don't need that much money. You can just use as much as you need at the time without having to go to a lender and ask to borrow the funds. When the bill comes due, you can choose how much you want to pay, provided you make at least the minimum payment. Plus, credit cards are usually pretty easy to qualify for, and there are options available for individuals with all credit histories.
With the exception of HELOCs, most revolving debt is unsecured. That means that if you were to fall behind on your payments, the lender might have no way to recoup their money because there are no assets they can seize and sell. Because of the increased risk, revolving debt tends to carry high interest rates. This means these credit accounts can get quite expensive if you end up carrying a balance from one month to the next.
The average credit card interest rate is 17%. If you owed $5,000, for example, and you could only afford to pay $250 each month, you'd end up spending an extra $921 over 24 months, assuming a 17% interest rate, in order to pay off that balance. Some people have trouble getting out of this cycle once they get into it, so it's important to use your revolving debt responsibly and spend only as much as you know you can pay back at the end of the month.
Installment debt gives you a large sum of money up front, and in exchange, you agree to make regular monthly payments over the term of the loan. A mortgage is an example of an installment loan, as is a car loan, student loan, or personal loan.
These loans are ideal when you need to make a large purchase, and they typically give you a fixed monthly payment so you know exactly how much you need to budget for it each month. Plus, in most cases, your interest rate is locked in, so it won't go up over time. Interest rates might also be much cheaper than what you'd find with revolving debt, though it depends on the type of the loan. Home and auto loans have collateral, which decreases the risk to lenders, so they tend to offer better rates. Personal loans, however, are often unsecured like revolving debt, so these interest rates might be higher.
Installment debt can be harder to qualify for than revolving debt, especially when you're borrowing large sums. Lenders will thoroughly examine your credit history and your income to assess how likely you are to be able to repay the borrowed amount. If you don't have much of a credit history to speak of, you may have trouble securing an installment loan on your own. You may need to find a co-signer or build up your credit with revolving debt before you apply for an installment loan.
Open debt is rare, and most people don't have it. The most common type of open debt is a charge card. Charge cards are similar to credit cards in that they enable you to purchase items on credit and come with a monthly credit limit that you can spend up to. But there are a few differences. Your credit limit can change from month to month, and you must pay your balance in full each month or else you'll get hit with expensive penalty fees.
Because these cards don't have a strict preset spending limit, they can sometimes enable you to make larger purchases than you could with regular credit cards. Some credit scoring models don't consider charge card balances, which can be a good thing if you're trying to keep your credit utilization ratio (the percentage of your total available credit that you're using) low. Ideally, you want your credit utilization ratio to be 30% or less in order to keep your credit score high.
Charge cards are risky for lenders because the debts are unsecured, and creditors stand to lose a lot of money if you don't pay back what you owe. For this reason, they're challenging to get, and only those with impeccable credit will be eligible for these cards. They also typically come with high annual fees and expensive penalty fees if you fail to pay your balance in full, so they're not a smart choice for everyone.
Too much debt is a bad thing
Having a mix of debt on your credit report is a good thing, as it shows lenders that you can be trusted to handle borrowed money responsibly. But it's not wise to take out loans just for the sake of diversifying your credit. Credit mix is only a small factor in your credit score, and borrowing money will raise your credit utilization ratio, which could lower your credit score.
Only borrow money when you actually need it, and make sure you can afford to pay it back when the time comes. Those same debts could just as easily sink your credit score if you fall behind on your payments or end up defaulting on the loan.