Managing personal finances can be tricky. Between rising mortgage rates, student loans debt, and increasing credit card debt it's no surprise Americans are racking up high debt levels.
According to the New York Fed, Americans’ debt hit a new high of $13 trillion last year, surpassing 2008's all-time high of $280 billion.
These debt levels are concerning since credit reporting and scores play key roles in the daily life of most Americans. As you probably know, your credit score can determine interest rates for credit cards, car loans, mortgages, or whether you’ll get approved at all. Lenders, businesses, and even employers will use your credit and debt levels to determine your reliability and if you're a high-risk borrower.
The mix of credit and debt are needed to build and maintain a credit score, but it's important to maintain a healthy balance between responsible credit use and the amount of debt you carry.
A major contributor to an individual's credit score is the use of credit. While opening and using different lines of credit can be great for your score, everything should be done in moderation.
Experts recommend keeping your credit use at no more than 30% of your total available credit. For example, if you have four credit cards with a combined credit limit of $6,000, then you shouldn’t use more than $1,800 at a time across all four cards. Carrying high balances or maxing out your available credit month-to-month could indicate to lenders that you are struggling financially and may have trouble making on-time payments.
The biggest risk of carrying large credit balances are the high interest rates associated with certain types of debts. Getting caught up in trying to pay balances while also paying interest rates on top of that can create a dangerous cycle, and over time it means less money in your pocket.
By keeping manageable balances (that make sense for the household's income) and making timely payments, you can uphold your financial reliability.
Good Debt vs. Bad Debt
For many people living completely debt free is unrealistic. The majority of Americans cannot afford to pay cash for some of life’s most important purchases, like a home, car, a college education, or startup capital for a business. The good news is that not all debt is bad.
Creditors and lenders consider good debt as investments that will grow in value or generate long-term income. A mortgage is one of—if not the largest—debts most Americans have; however, this is considered a good debt due to the low-interest rate and future profit potential. These types of good debts are seen as lower risk items to lenders and as long as payments are kept in good standing they will not have a negative impact on credit scores.
On the other hand, large amounts of bad debt are seen as red flags to lenders and can negatively impact your credit score.
Bad debt is typically used to purchase items that will lose their value quickly or do not generate long-term income. Bad debt is also tied to higher interest rates via credit cards or payday loans. If you find yourself maxing out credit cards with shopping sprees and not paying the balances in full each month, a lender will recognize this as irresponsible and risky.
Getting caught in the cycle of bad debt and high interest rates increases the probability of unnecessary bills and can make it difficult to keep up with payments.
A safe rule to follow to avoid bad debt is to avoid purchasing non essentials if you can't afford to pay for them with cash.
Using credit and debt responsibly is a matter of making wise financial decisions and living within your means. In order to balance responsible credit usage and debt, strive to regularly and responsibly utilize a mix of account types, while also paying all bills on time, keeping your balances low, and applying for new credit lines only when needed or to build wealth.
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