There are two goals that many people strive to attain in order to have a solid financial foundation. The first is creating and maintaining good credit history. The other is move through life without incurring debt. Surprisingly the two do not go hand in hand. Many consumers are under the false impression that living a debt free life equates having good credit. To understand why debt is needed for good credit you must first understand how credit and debt work together to give lenders a "snapshot" of your financial track record.
How is your credit score calculated?
While there are a number of complex factors involved in determining your credit score let's look at the basic outline to see how your credit score is calculated.
* Payment History- Counting for roughly 1/3 (35%) of your credit score is your payment history, which basically is a record of how timely you are paying your bills. This is why there is so much emphasis on paying your bills on or before the date they are due. Making late payments not only makes you vulnerable to late fees and increased interest rates, they are a black mark on your credit report.
* Amount of Debt-The next largest factor (30%) contributes to your credit score calculation is the level of debt you currently have. This is compared to your income and the amount of credit available to you.
* Length of credit history- Approximately 15% of your credit score is determined by the length of your credit history.
* Credit Inquiries- Have you recently applied for a credit card, mortgage or car loan? Ten percent (10%) of your credit score is determined by recent credit inquiries. The fewer inquiries the better as multiple attempts to garner credit may be viewed as a sign of financial distress.
* Type of debt- There are different types of debt and they are viewed differently when calculating your credit score. The remaining 10% of your credit score is determined by the type and amount of debt you are carrying. For example if a large percentage of your current debt is your mortgage or car loan that is viewed more favorably than having the same amount of debt from credit cards or payday loans.
Now that you can see what factors are contributing to your credit score it should be clear why having no debt could have a negative impact on that score. With that in mind, your credit history is a tool for lenders to use to determine how likely you are to pay back a financial obligation. By having or using credit responsibly you will establish a positive history of using and repaying credit.
Living a life free of debt should always be your goal and you definitely should not rack up debt or get a loan for the sole purpose of creating a history of payments. However you should understand that having a good credit history or score is equally important when it comes to proving you are worthy of credit. By understanding how debt and credit work, you are more likely to find the balance to achieve these two important financial factors.