Knowing how credit and debt work means knowing that they are part of a cycle.
What comes first? What follows later?
Your ability to borrow money and the resulting debt. In other words, when you use your credit card, you go into debt.
The higher the amount borrowed, the higher the debt will be. So, the more in control you are of your debt, the longer you will have access to higher credit in the future. It’s basic math.
You need to process personal data such as your loans and make sure that you make payments on time.
Before we begin, you need to know the basics of credit and debt to understand better how they relate. Let’s take a look at the whats and whys of them:
What is credit?
“A certain amount of money that some can borrow.”
A credit card allows you to purchase things using borrowed money. For example, a bank issues you a credit card to make purchases. The money you use is to be paid later to the bank when you receive your credit card statement.
If you have an open line of credit, you can borrow and repay the money according to the agreement with your bank. Lastly, the amount set by the bank that allows you to borrow a specific amount is known as your credit limit.
“A tall tale of how you have managed your credit and debt in the past years.”
Your credit report outlines many things, such as the credit you have used so far, how much you have paid off, the leftover debt, and the remaining credit amount.
The tale of your credit report has an ending, which is called your credit score. According to Experian, the no.1 consumer credit reporting company, credit scores are divided into different categories that help lenders decide whether the person applying for more credit is eligible or not. The credit score represents their ability to pay the debt on time.
Here’s how the FICO® Score works:
- Exception: 850 – 800
- Very Good: 799 – 740
- Good: 739 – 670
- Fair: 669 – 580
- Poor: 579 – 300
Compared to a credit card, a charge card forces you to be more responsible with your spending. Instead of paying off the debt after a specified amount of time, you have to pay it at the end of each month. One of the biggest benefits of a charge card is that it does not have a credit limit, but some lenders enforce a soft limit based on how much you can afford.
What is debt?
“Money borrowed but has not been paid back.”
Any amount of money that you borrow via your credit card and don’t pay back is the debt you carry. For example, you buy something for $100 and don’t pay it back.
The more purchases you make, the higher your debt climbs. This, in turn, affects your credit score and makes you ineligible for a loan or a higher line of credit.
A great way to make sure that you don’t fall into debt is to go for secured debt. This is a type of debt that allows you to put up collateral for the loan.
For example, if you are applying for a mortgage and don’t have the down payment for it, you can use an asset such as your car in its place.
In the event you default on the loan, the lender will take the car and cover his loss. This won’t have any effect on your credit rating if the asset fully pays for the loan.
Revolving credit and debt
Revolving credit allows you to borrow money at any time, as long as you pay a portion of what you spend. When payments are made regularly, your line of credit is replenished.
As for revolving debt, it refers to your credit card balance, which is carried from one month to another. It encompasses your debt, which isn’t a set amount of loan. Instead, it refers to the minimum payment required as you pay down a small portion of the debt and take more on ― hence the name revolving credit.
Now, let’s talk about how credit score and debt co-relate:
The co-relation between credit and debt
Nowadays, your financial life cannot continue without borrowing money. Credit bureaus have made it extremely easy to apply for a line of credit by providing people full access to their credit scores and report. This way, you can decide how high of a credit limit can handle.
Credit, in other words, is called debt. As its money borrowed that you don’t have but need it for personal finance and wants. Don’t confuse the word “debit” with debt, which refers to paying money directly from your account.
How your debt to income (DTI) ratio works
Your DTI is based on your credit utilization. The golden rule is that you need to stay below 30%. Your DTI is the amount of debt you create every month divided by your total income.
If your DTI increases above the 30% mark, it affects your credit score. This doesn’t mean that you won’t get a line of credit if you have a 50% DTI. They will simply charge a higher interest rate.
The DTI ratio includes your monthly debt, which is your credit card balance, car loan, mortgage payments or rent, and more. As for the monthly income, it includes the salary you earn before taxes, expenses, and withholdings.
For example, you earn $12,000 in a month. This is your gross income. Your monthly recurring debt is $4,000. Based on these numbers, your DTI is 33%, which is somewhat acceptable. It shows that you are currently standing on the edge of debt, and with a little management, you can easily scale back the ratio.
How your DTI affects your credit score
Always aim for a good credit score. It opens many opportunities for you, such as being eligible for multiple lines of credit. However, make sure that you pay your debt on time because a single late payment can cause your credit score to fall and compromise your future eligibility to apply for any kind of loan.
How you handle your debt also affects your credit score. For example, you have just bought a house and are currently using your credit card to make all the payments.
When it’s time to make your next monthly payment, you realize that you don’t have enough credit. You talk to your lender and push the payment to next month.
When your salary arrives, most of it goes into paying for utility bills, groceries, and a few necessary repairs. With two missed payments, you are now in debt, in addition to the money you haven’t paid back on your credit card.
All these missed payments will show up on your credit report, and the more time you take to repay them, the lower your credit score will fall.
To maintain your DTI, you need to look at your personal data to make sure that your credit card balances are not getting out of line. Moreover, keep an eye on your credit reports to prevent discrepancies in them, as this can also affect your credit score.
Multiple missed monthly payments will lead to too much debt, which will limit your spending ability. The higher your credit limits, the more difficult it will be for you to pay down your debt.
Hence, you should think twice before borrowing money because when a lender processes your personal data, a negative mark on your credit report will compromise your eligibility to apply for loans.
So, take a look at your credit score and track your credit reports to find out where your credit rating has been taking a hit to manage your debt. Your debt affects your future spending ability so imagine how amazing it would feel to be debt-free by simply managing your line of credit.