4 ways good debt can improve your credit score

The word "debt" typically carries a negative connotation, especially among new savers. But contrary to popular belief, debt isn’t always bad. In fact, taking on "good debt" can not only boost your personal wealth in the long run, but it can also improve your credit score along the way — setting you up for a more successful financial future.

Using ‘good debt’ to improve your credit score

What is ‘good debt’?

According to Rod Griffin, director of public education for credit bureau Experian, good debt ‘is any debt that offers a return on the investment.’

For example, a mortgage is considered good debt since ‘in normal times, [the home associated with it] has some gain in equity,’ Griffin says.

Credit cards can also be a form of good debt, as many consumers are able to steadily build their credit score by accumulating debt and paying it off on time. Until you take on debt, you are usually stuck with either no credit history or a low credit score. So in order to increase your credit score — and set yourself up for future bigger purchases such as a home — you have to take on good debt and pay it off in a timely manner.

"Most people need to borrow money to buy life’s ‘big-ticket’ items," says Paul Kuzmickas, a bankruptcy attorney. "While some might consider all debt as bad debt, that is not always the case. There are several forms of debt that can be viewed as good or smart debt."

Lenders use your credit score to determine your interest rates. So having a good score will not only put you in a better position when it comes time to qualify for a mortgage, but it will also help you get lower interest rates on things like car insurance. In some cases, it can even impact your ability to get a job. 

So here are a few ways to use good debt to improve your credit score.

4 ways ‘good debt’ can improve your credit score

1. Make on-time payments

Your ability to make on-time payments accounts for 35% of your total credit score. So in order to make debt work in your favor, you must pay it off on time and in full each month. This goes for credit cards as well as  any other monthly bills you may have. The better your on-time payment history, the better your credit score.

If you open a credit card to help improve your credit score, the best way to make it work for you is to put a few things on the card that you know you can pay off in full at the end of each month. Paying off that credit card bill each month will then help boost your credit score and your record of on-time payments.

2. Keep a low credit utilization rate

The amount of your available credit you use makes up 30% of your credit score. So when you open a credit card, the idea is to use only up to 30% of the credit limit and then pay off whatever you owe in full at the end of each month.

Here’s an example: Let’s say you have a credit card with a $10,000 limit. If you’re carrying a balance month-to-month of $3,000, you’re only using 30% of the total limit. But if your credit limit is suddenly dropped to $3,000, then suddenly you’re using 100% of what’s available to you. That’s yet another reason to always pay down credit card debt as quickly as possible. You always want to stay at credit utilization of 30% or less. 

Keeping your rate of credit utilization low will help you improve your credit score over time.

3. Use debt to accomplish a goal

Certain types of debt that help you get ahead in life can be considered good debt — and can help you build a more successful financial future. 

While a mortgage is one good example of this, as mortgage debt allows you to buy a home you can build equity in, student loan debt can also be a good way to get ahead in life. ‘Student loan debt helps you gain a college degree, one of the best ways to ensure that you’ll earn more money throughout your adult life,’ Rafter says.

‘While the media are very concerned — rightfully — about the amounts of debt students are graduating with, student debt can be very beneficial,’ says Eric Meermann, portfolio manager with Palisades Hudson Financial Group’s Scarsdale, New York, office. ‘Taking on this debt allows you to improve your skills, gain an education and a degree and hopefully make yourself more marketable to future employers.’

Just make sure that if you do take out student loans, you’re doing it the right way. As a general rule of thumb, you don’t want to borrow any more than what you expect to earn your first year out of school. 

4. When you pay off a credit card, don’t close the account

This accounts for 15% of your credit score and coincides with your credit utilization rate.

Closing a paid-off account only reduces your available credit and drives your score down. You want to have between four to six lines of credit, including loans, credit cards etc. Be sure to use credit cards at least twice a year — even if it’s just for a dollar store purchase — and pay them off right away. That will keep them active in your credit mix.

If you’re facing a huge new annual fee on a card that has a zero balance, try ‘leapfrogging’ — using the 45-day window you have before any new terms of service go into effect to shop around. So once you get a notice about a new annual fee, start looking around for other no-fee credit cards. Submit your application and once you get your new no-fee card, then go ahead and shut down the original one that wanted to spring a fee on you.

debtAlex Thomasblog, featured