Understanding the Impact of Debt Management on Your Credit Score

One way to think about tackling financial wellness in three parts: dealing with your past, managing your present, and planning for your future. Debt falls squarely in the "past" category. When we have debt, it can feel like the past colliding with the present and interfering with the future. Debt is the financial obligation looming over your head that you're on the financial hook for paying for something that you purchased or took out a loan for in the past.

If you feel like you've been moving up a rock up a hill on your debt load, without much rest, there is a sea of fellow sufferers. Recent data from the Federal Reserve reveals that in the second quarter of 2024, household debt in the U.S. rocketed by $109 billion and is now a staggering $17.80 trillion. Additionally, per the TransUnion Q2 2024 Credit Industry Insights Report, the average credit card debt by borrower is $6,329.

Debt management can feel like a Herculean feat, especially when you're trying to juggle debt with the financial needs of the present and goals of the future. However, not tending to one's debt in a responsible manner can have a direct impact on credit scores. So what will happen if you don't manage your debt wisely?

Here, we'll explore the potential consequences of poor debt management and provide actionable debt management strategies:

Understanding Credit Scores and Their Components

A credit score uses a scoring model, which is a mathematical formula, to generate your credit score. They help lenders and creditors gauge your creditworthiness, or how likely you are to pay back your debt.

Data is pulled from your credit report, which is produced by the three credit bureaus–Experian, Equifax, and TransUnion. Credit scores are a three-digit number and fall between 300 and 850, with 300 being a poor score and 850 being an excellent score. The higher the score, the less of a risk you are deemed in the eyes of lenders, and vice versa.

Here are the credit score ranges per FICO®:

• 300 to 579: Poor
• 580 to 669: Fair
• 670 to 739: Good
• 740 to 799: Very Good
• 800 to 850: Excellent

There are five main factors that contribute to a FICO® credit score:

1. 35%: Payment history
2. 30%: Amounts owed
3. 15%: Length of credit history
4. 10% Credit mix
5. 10% New credit

Two main brands of credit scores prevail– FICO® and VantageScore®. When you get a credit score, it's based on just one scoring model of many. There are dozens of scoring models, and different ones can be used for car loans and credit cards. The most commonly used credit score model is the FICO score, which according to FICO is used by 90% of top US lenders.

The Impact of Poor Debt Management on Your Credit Score

Debt mismanagement can negatively impact your score. This includes falling behind on payments – or missing payments altogether, keeping a high credit card balance, or maxing out on your credit.

Late payments impact your payment history, which makes up a significant chunk (35%) of your score. They can linger on your credit report for up to seven years. How much it can decrease your score depends on how late you were on the payment and your credit score.

Per FICO simulated data, if you miss a payment by 30 days, it can cause a fair score (607) to dip anywhere from 17 to 37 points, and an excellent score (793) can see a decrease of 27 to 47 points. If you miss a payment by 90-days, a fair credit score could decrease 27 to 47 points, and an excellent score can lower by 113 to 133 points.

When you rack up a high credit card balance, it increases your credit usage, which makes up for 30% of your score. Ideally, you want to keep your credit usage as low as possible. Aim for 10% or lower, but no more than 30%. So if you have a total card limit among all your cards of $10,000, if possible, you don't want to have a balance that's higher than $1,000.

A maxed-out card could result in a sudden dip in your score. Plus, it could up your minimum payment amount, and future transactions on that card could be declined. If you go over your credit limit, the credit card company might hit you with a penalty APR, which might be as high as 29.99%.

Common Mistakes in Debt Management

As you can see, letting debt management fall by the wayside can result in a major credit score impact. Let's look at some common mistakes:

Missed payments. When you miss payments, not only does it negatively impact your credit, but it also can result in late payment fees. Once a late payment hits the 30-day mark, it can get reported to the credit bureaus.

You'll also end up paying more in interest fees, and falling behind in payments can lead to a cascade of bills you need to catch up, which can impact your cash flow. And down the line, if you have a history of late payments, a lender may charge you higher interest rates on new lines of credit.

Relying too much on credit cards. As mentioned, having a high balance on your cards means a high credit utilization ratio, which can hurt your score.

Leaning too heavily on credit cards can make it hard for you to have a positive cash flow. You might find yourself in a place where you're juggling multiple debts and may struggle to keep up with your payments and cover your daily living expenses. Soon enough, you might find yourself in a vicious cycle where you need to rely on your credit cards to cover everyday essentials.

Plus, when you're running up a balance on your cards and only making minimum payments, the money you put on your card will cost you more in interest. Your payments could also be eating up the potential to use your hard-earned cash on your financial goals.

Applying for multiple cards and loans. Applying for too many credit cards and loans at once signals to borrowers that you might be hurting in the money department. And multiple hard pulls on your credit around the same time can lower your score more so than a single inquiry.

However, if you're shopping around for a mortgage, car loan or utility company, several inquiries can count as a single inquiry. The time frame hinges on the scoring model, and can be anywhere from 14 to 45 days. In turn, your score won't take such a hefty hit.

The Consequences of a Lower Credit Score

A poor or fair credit score is undesirable – but why? Let's look at the consequences of having a lower credit score:

Higher interest rates. Higher interest rates means you're paying more for the same amount of money borrowed. For example, you have a credit card balance of $5,000 and the interest rate is 20%. If you pay off the balance in 12 months, you would owe $558 in interest. If you have the same balance but an interest rate of 26% and pay it off in 12 months, you would pay a total of $731 in interest.

Reduced odds of loan approval. A lower credit score could bump down your odds of getting approved on a loan. That's because the higher your score, the better your chances of getting approved. Additionally, you'll likely get more favorable terms.

Can impact life milestone purchases. When you have to deal with higher interest rates, lower odds of getting approved for financing, and less attractive terms, that means it could be more challenging to afford major, life-changing purposes, such as buying a house or car.

If you aren't able to secure the amount you need on a mortgage, you'll have to put a hold on that goal until you can build your credit. If you do secure a mortgage but with higher interest rates due to not-so-great credit, that mortgage will be more expensive.

Good Debt vs. Bad Debt: Understanding the Difference

Debt can fall into two camps: bad debt and good debt. Good debt is debt that can ultimately build wealth, improve your finances, or lead to opportunities that can improve your money situation.

For example, taking out a loan to buy a house or student debt for higher education are examples of good debt. That's because a house can increase in value, and you can build equity to purchase another property down the line.

Bad debt is debt that can drain your finances, don't offer long-term value or is something that you struggle to pay off. For instance, high-interest credit cards and payday loans are forms of bad debt.

Ideally, you should aim to pay off your debt as soon as possible. But if you have high-interest credit cards or payday loans, you might want to knock those out first. That's because not doing so can eat up a lot of your funds in interest cost. At the minimum, keep up with all your minimum payments.

How to Manage Debt Wisely to Protect Your Credit Score

To safeguard your credit score, you'll want to make it a priority to manage your debt wisely. Here's what you can do:

• Create a debt payoff plan. Track your debt by noting the initial amount, the remaining amount, the interest rate, and the monthly payment. It's also a good idea to note the fees and terms. You can use a debt payoff tracker to help you keep tabs on your debt.

• Set up autopay. Automating payments is a surefire way you won't miss a beat on your monthly debt payments. Besides scheduling your payments, make sure you have enough shored away in your linked account to cover your payments each month. If you are still struggling, change your due date so it's aligned with your cash flow.

• Set up notifications. Set up alerts to receive via text or email, alerting you of your current statement balance, recent purchases, payment due dates. This will help you keep track of how much you're carrying on your card.

• Keep credit utilization low. As mentioned, the lower your credit usage, the better. This does make up 30% of your credit score, so you'll want to keep watch of your usage. Do your best not to put unnecessary purchases on your card.

• Pay off balances in full. If you are able, try to pay off your balances in full each month. That way, you avoid paying interest, and by making on-time payments you can steer clear of any potential late fees.

• Avoid unnecessary debt. Credit card debt can sometimes feel like "fake money." In other words, these digital transactions seem like they have no tangible basis. In turn, it can be easy to buy things you don't need and rack up a balance. Instead, do your best to take out debt for things you absolutely need or for things that can add a long-term financial benefit.

• Consider debt consolidation. Debt consolidation is when you lump together multiple debts into a new, single loan can lower your monthly payments, lower your interest rate, or both. You'll want to weigh the pros against the cons first before determining whether it's the right choice for you.

Steps to Improve Your Credit Score After Mismanagement

Once you've recovered from the throes – and consequences – of poor debt management, aim to stay in a good place debt and creditwise. Consider doing the following:

Monitor your credit. If you are a Self customer you can monitor your credit. Plus, Self will notify you of any chances to your credit profile.

Order a credit report. You can also review your credit report and see if there are any inaccuracies. You can order one for free at AnnualCreditReport.com. Certain errors and missing information, such as on-time payments mistakenly reported as late, can negatively impact your score.

Make a series of consecutive, on-time payments, and some secured cards may give you the option to move to an unsecured card or a higher credit limit.

Seek professional advice. Working with a credit counselor can help you pay back your debt with a customized plan, and help you avoid repeating the same mistakes. Plus, they can answer your questions and offer additional guidance. You can find such a professional through the National Foundation for Credit Counseling (NFCC).

Frequently Asked Questions

• Does your credit score go down if you don't spend? Your spending habits and behaviors don't impact your credit score. It's your payment history and credit usage that can impact your credit score.

If you don't use a credit card for a length of time, it can help your score because it adds to your overall credit limit. This in turn can lower your credit utilization ratio which can help increase your score.

• Why is my credit score going down if I pay everything on time?
  Despite a history of on-time payments, your credit score could go down if your credit usage is too high, you've maxed out on a credit card, you've applied for too many credit cards or loans at the same time.

• Is having zero balance on a credit card good?
  A zero balance on a credit card means you don't have to make any payments on the card, which means you don’t have to make a monthly payment and you will not incur interest charges. Contrary to popular belief, you don't need to carry a balance to have a good score.

Making on-time payments, keeping your credit usage low, not making unnecessary purchases and avoiding applying for too many loans at once can help with a good score.

Conclusion: Taking Control of Your Financial Future

It's easy to put the blinders on when your debt situation feels overwhelming. But letting your debt payments fall by the wayside can ding your score–and hurt your overall finances.

The road to credit score recovery doesn't happen overnight. By minding debt management tips, you can recover from old habits and maintain and build strong credit. If you need support in prioritizing financial health, seek professional guidance.

You can see if your current employer has free or low-cost options for financial coaching or credit counseling. You can also try searching through the Foundation for Financial Planning's directory, which includes nonprofits that work with CFP® professionals who offer pro bono financial planning. Over time, you'll see an overall improvement. You've got this!

About the author

A personal finance writer for over 8 years, Jackie Lam covers money management, lending, insurance, investing, and banking, and personal stories. An AFC® accredited financial coach, she is passionate about helping freelance creatives design money systems on irregular income, gain greater awareness of their money narratives, and overcome mental and emotional blocks.

Her work has appeared in publications such as Bankrate, Time's NextAdvisor, CNET, Forbes, Salon.com, and BuzzFeed. She is the 2022 recipient of Money Management International's Financial Literacy and Education in Communities (FLEC) Award, and a two-time Plutus Awards nominee for Best Freelancer in Personal Finance Media. She lives in Los Angeles where she spends her free time swimming, drumming, and daydreaming about stickers.

Editorial policy

Our goal at Self is to provide readers with current and unbiased information on credit, financial health, and related topics. This content is based on research and other related articles from trusted sources. All content at Self is written by experienced contributors in the finance industry and reviewed by an accredited person(s).