Stop Focusing on Your Credit Score if You Are Drowning in Debt

Key Takeaways

• Credit scoring companies like FICO use multiple factors to create your credit score. Late payments and high debt levels have the biggest impact on your score.
• Credit is only critical when you are in the market for new debt. If you do not plan to make a large purchase over the next couple of years, a lower credit score may have little effect on your overall financial wellbeing.
• While derogatory marks remain on your credit file for seven years, the largest impact occurs in the first 12 months. You can even qualify for a mortgage with a foreclosure on your credit report, as long as it occurred at least three years ago.

Everywhere you turn these days, someone is offering to give you a free copy of your credit report and credit score.  Recently, credit scores started showing up in many credit card statements, further adding to the fixation Americans have with their credit score.  We have become a nation obsessed with credit scores but, in fact, your credit score matters less than you might think; and here’s why: 

It all began in 2014 when the CFPB (Consumer Financial Protection Bureau) began pushing banks and credit card companies to give consumers free access to credit scores. Soon advertisements from companies like Credit Karma began promoting credit as the one and only way to achieve financial success.

If you want to get out of a bad roommate situation, get a raise, or move to the suburbs, improving your credit score was the answer they all touted. 

The trouble is, that like most one size fits all solutions, the hype does not live up to reality. 
While credit does factor into your ability to get a loan, your credit score matters less than you think, when it comes to reaching your financial goals. Here are the reasons you should stop focusing on your credit score if you are drowning in debt: 

What Credit Scoring Companies Care About

FICO and Vantage, the two major credit scoring companies, use similar algorithms to calculate your credit score. The key factors include the following:

On-Time Payments – Over a seven-year timeframe, the credit scoring algorithms track account payments with particular emphasis on late payments. Delinquencies within the last 12 months count the most.  

The Utilization Ratio – Is a calculation that summarizes the amount of available revolving credit you have in relation to your credit limits. When you maintain higher balances, it can impact your score nearly as much as a late payment.  

Overall Credit History – Considers the average age of accounts.  

The Number of Loan Applications – And new credit accounts for two years.

Credit Mix – This is the number of loans versus lines of credit.

Your Credit Score is a Measurement of How You Manage Debt, Not a Reflection of Your Wealth or Financial Stability

Since 35% of your credit score is made up of factors related to the amount of debt you owe, and another 30% of your score is determined by your payment history of outstanding debt balances, a full 2/3 of your score value is derived from the debt balances you carry and your ability to service that debt through timely payments.  Given this, having no outstanding debt balances on your credit report, and thus making no monthly payments to service any debt, a lack of payment history and outstanding balances can be as much of a negative factor when calculating your credit score as having a high utilization ratio on outstanding balances and making late payments or missing payments altogether.

What Lenders Care About

Lenders care about more than just credit and your ability to service outstanding debt. A bank wants to see decent credit, some assets, strong and reliable income. They want to have confidence that you can repay the debt. Credit only looks at past behaviors. A good job is an indication of your ability to make future payments on the additional debt. Demonstrating the ability to repay the debt is as important as your credit score to many lenders today. 

Drowning in debt with maxed out credit cards means you cannot manage the debt you have, let alone take on additional debt, even if you have a good credit score.  In this case, focusing on your credit score, while you pay thousands in extra credit card interest each month while only making minimum payments, is denying the obvious and deferring your ability to become debt-free. 

What YOU Care About!!

Most consumers want financial stability and security. Having stellar credit may be less important if you don’t face major changes on the horizon. For example, if you plan to live in the same home, drive the same car, and keep the same job, a temporary decline in your credit score may have a minimal impact on your finances. Each person’s situation is uniquely different, and you should evaluate your short-term and long-term financial needs and goals, but deferring purchases requiring an A+ credit score for a few years may benefit you more in the long run by putting you in a stronger financial situation before taking on any additional debt obligation

 Why Cash Flow Matters More Than Credit

High debt balances can strangle your cash flow. It can create a situation where you cannot improve your finances or your credit because you can only afford minimum payments on revolving debt. When you have little left over to fund an emergency account, retirement accounts, or other financial needs, credit may not be your biggest problem or concern. 

Spending 30 years or more struggling with credit card payments can put you behind in other financial areas of life, which could impact your financial health well into your retirement years. Paying high interest on your accounts for decades can also have a multi-generational impact on the financial well being of future generations by reducing the wealth transferred to your beneficiaries upon your death.

Conclusion

Stop obsessing about your credit score if you are struggling with high-interest credit card debt.  It’s not a reflection of your wealth or financial stability, and the last thing you need is a great credit score to help you add more debt payments to make each month.  Your credit file and credit score are only a small part of your overall financial health picture. Focus on the things that matter when it comes to putting together a plan to get out of debt.  Adding more debt to the equation WON’T help you reach your goals faster.

FAQ

• Why is my credit score low when I have never missed a payment?

  On-time payments are only one of five main factors affecting your credit. High credit balances, especially on credit cards, can affect your score almost as much as a missed payment. FICO values on-time payments at 35%, and the amount of revolving debt you carry in relation to your credit limit at 30% of your score. 

• Will paying off my debt raise my credit score?

   Reducing debt is the second most important factor in your credit score. Second only to paying bills on-time. The more you lower your utilization ratio, the better your credit score will be. 

• How much does my credit score really matter?

   Having excellent credit is not an essential element of financial success. It is merely a tool that allows you to leverage debt to build wealth. However, if you use credit unwisely it can result in too much debt and a lower credit score, which will make it harder to borrow money when you need to.