You may already know too much debt is bad, but did you know not enough debt might not be good, either? Read on to find out how having too little debt can impact your credit score and your ability to get a mortgage.
You may already know that having too much debt is a bad thing, but did you know there is such a thing as not enough debt? You need some debt to maintain a good credit score and qualify for a mortgage, but not so much as to overextend yourself. Here, we look at what type and how much debt can be beneficial for your financial well-being.
Not all debt is created equal, and some types of debt are better than others.
When determining if having no debt can be a bad thing, it’s important to know what type of debt is out there.
There is Such a Thing as “Good Debt”
Good debt is an investment that will help you generate income or increase value either in yourself or something you purchase. These types of debt include:
- Student loans – Student loans can help you obtain an education that may give you more value as an employee, allowing you to earn hundreds of thousands of dollars more over the course of your career.
- Home loans – One of the fastest ways to build wealth is to purchase a home. Mortgages provide you with a place to live and will build you equity.
- Small business loans – These can help you start your own business. Not only can you earn a living through your business, but also you can avoid reliance on someone else for your paycheck and live life on your terms.
This type of debt may also be tax deductible as you can claim certain educational costs, mortgage interest payments and insurance off your taxes each year.
There Is Also Bad Debt
On the other hand, there’s bad debt that offers a bad return or no return at all. These include:
- Auto loans – As soon as you drive off the lot, your new car will depreciate. A vehicle may be a necessity to get to work or run errands, so it isn’t necessarily a bad purchase. A car just doesn’t offer a great return on your money, and paying interest on it will make it more expensive than you may think.
- Credit cards – Credit cards have some of the highest interest rates around, so any amount of money left on your card at the end of the month is bad. Most goods and services you’ll put on your credit cards won’t increase in value over time (think of the clothes you just purchased or that vacation you charged). If you don’t pay them off right away, you’ll end up paying significantly more on them than you may have intended.
Too Much Debt Is a Problem
While not all debt is created equal, it’s important to not overextend yourself with too much of any debt, as it negatively impacts several aspects of your financial life. For one, debt costs you money through interest rates. The higher the interest rate, the more you’ll end up paying for products, so in the long run you may end up paying more than the item is worth.
Debt also impacts your credit utilization, which is the second most important factor in determining your credit score. Credit utilization is the amount of debt you have relative to your credit limit or the amount of credit that has been extended to you. To maintain a good score, your credit utilization ratio should be no more than 30%.
If you go higher than 30%, your credit score will be negatively affected, which will impact the interest rates on future loans. More importantly, you may be considered a higher risk to lenders, which can prevent you from borrowing money in the future.
Not Enough Debt Isn’t Great, Either
Conversely, if you have little or no debt, it’s harder for you to prove you’re a responsible borrower to lenders. You haven’t been able to show you can keep up with payments and for lenders, that means you’re an unknown risk.
Once you have debt, whether it is in the form of student loans, credit cards or a mortgage, you can show you’re responsible when given a loan and that can help you borrow in the future.
Having no debt can also impact your credit score, as it could mean you have a shorter or nonexistent credit history. Nearly 15% of your score is based on credit history, so a shorter history can translate into a lower score. Lower credit scores result in higher interest rates when you get a loan and could even make it difficult for you to qualify for a loan or purchase a house in the future.
Everything in Moderation
As it is with most things in life, it’s best to exercise moderation when borrowing money. Having some debt in and of itself can be a good thing. Often what we want is out of our reach without a loan, and we need them to help achieve our dreams of going to college, starting a business, and purchasing a home. The most important thing to remember is to pay your debt on time and in full when it’s due.
There is no formula for the perfect amount of debt you should have. To qualify for a mortgage, lenders typically want to see a debt-to-income ratio of less than 43% to ensure you have the means to pay back the money you’ve borrowed. If you have more than this, paying down your debt before applying for a mortgage or other type of loan can help you qualify.
If you have no debt at all, don’t worry! You can become a co-signer on a loan or take out a credit card to help build your credit history and prove you’re a responsible borrower. This will help prepare you for your next big purchase and qualify for the loan you may need to finance it.
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