Good Debt vs. Bad Debt: How to Balance Your Credit

John Vaughan (Financial Advisor) @ Lucid Living

Most people realize that the amount of debt they carry directly affects their credit score in terms of whether or not they are seen as a good credit risk. But potential lenders also take into consideration the type of debt you carry when making a judgment call about whether or not to extend credit to you.

Having the wrong balance of credit types can mean a significantly lower credit score, and that can lead to higher interest rates, lower credit limits, and in some cases, denied credit applications.

Good Debt
The term ‘good’ debt applies to almost any type of credit or loan that helps you to make tangible progress in some way. They may be secured loans, such as for a home or a car loan, or they may be unsecured, as in the case of student loans. In all cases, however, this type of debt demonstrates a commitment, or responsibility that is directly correlated to responsible lending habits. By having a home, you demonstrate stability. Student loans are generally seen as a good thing, as higher education often yields a better job, and thus, an individual who is better capable of paying off his or her debts.

However, you should be careful with this kind of debt, just as you would any other. Falling behind on a home loan in today’s financial climate can lead to reposession and a blacklisting on your credit report. Student loans that are unpaid will go into default, leaving you unable to further finance your education, along with other detrimental effects, not the least of which being the damage to your credit score.

Bad Debt
So-called ‘bad’ debt isn’t necessarily bad, but like all forms of credit, it should be used in strict moderation. Bad credit encompasses things like credit cards, store credit, and revolving accounts that can be used for purchases of less than essential items. While credit cards are not bad in and of themselves, carrying too many credit cards or too much of a balance on your credit cards can cause your credit score to dip dramatically.

The best advice when it comes to credit cards and store credit is to only use what you need and to keep your balances as low as possible. In this way, you demonstrate responsible credit consumption, and your credit score won’t take a hit from having too much debt on unsecured credit cards.

The Balance
Ideally, you should have a good mix of secured and unsecured credit, which demonstrates both stability and responsible credit consumption habits. As much as 10% of your credit score can be determined by the type of credit you have, so be careful not to open a lot of credit card accounts, especially if you don’t have a home or car loan to offset the difference. You should also avoid going the other route – avoiding credit cards entirely and paying only with cash or debit. If you don’t have any payment history with unsecured loans, some lenders may be reluctant to extend credit on favorable terms.

In general, when considering new credit, ask yourself if you really need it, or if it’s just going to be one more credit card to add to the pile. Taking advantage of a low interest rate to pay down a few balances is more than acceptable, but opening an account just for an introductory discount on purchases might not be – especially if you don’t really need the items you would purchase.

Keep your financial goals in sight, and you can take full advantage of both types of credit, while still improving your credit score.