While borrowing money can affect your credit score, being in debt isn’t necessarily a bad thing.
The mere mention of “debt” can be enough to send some people into a panic, but this is one four-letter word that isn’t always as offensive as you may think. In fact, going into debt isn’t always bad and it can actually be a positive thing if it helps you create wealth.
However, it’s important to be aware of the difference between good and bad debt and the impact these can have on your credit score before you borrow money.
Good debt vs bad debt
Before going any further, let’s start with the question that’s probably on the tip of your tongue: how can debt possibly be good? It sounds counterintuitive to describe owing money as a positive thing, but bear with us.
Good debt is basically any type of debt that helps you create wealth. So if you borrow money to buy an asset that will provide an income or rise in value over time, this is considered to be good debt. Examples of good debt include home loans, tax-deductible investment loans and even student debt that helps you pay for the education you need to enjoy better career prospects.
On the flipside, bad debt is any sort of debt that reduces your wealth. Any debt that isn’t tax-deductible or that is used to buy assets that will depreciate in value and/or won’t provide an income falls into this category. Examples of bad debt include using credit card or personal loan debt to buy a car or pay for a holiday.
How does debt affect your credit score?
Your credit score is calculated based on the information in your credit file, which contains a range of important details about your current financial situation and history. There’s a wide range of information included in your file, such as:
- Overdue debts
- Missed payments on loans and utility bills
- Bankruptcy information
- Court writs, summons and judgments related to settling your debt
- Debt agreements
- Personal and business credit applications you've made in the last five years, regardless of whether they were approved or not
- Your monthly repayment history on credit accounts
When you apply for credit, your lender will review your credit score and the information in your credit file before deciding whether you can afford to repay the money you borrow.
Does debt negatively affect my credit score?
Yep, debt can certainly have a negative effect on your credit score. When does this happen? Examples include:
- If you have excessive debt. If you’ve taken on multiple debts or large amounts of debt, the chances of you being able to afford to repay any future credit are greatly reduced. As a result, this will negatively affect your score.
- If there are defaults on your credit file. A default is any consumer credit account that is more than 60 days overdue and where you owe $150 or more. If you fall behind on repayments and a default is listed on your credit file, it stays there for five years and will drag your credit score down.
- If you’ve been late making payments. An accidental missed payment probably won’t affect your credit score too much, but if you’re regularly late making loan repayments, expect this to adversely impact your score.
- If you’ve had serious problems with debt. If you’ve entered into a debt agreement, been served with a writ or summons, or filed for bankruptcy because you’ve been unable to service your debts, your credit score will suffer.
Can debt positively affect my credit score?
Debt doesn’t necessarily drag your credit score down; in some cases it can actually improve your credit rating. Since March 2014, Australia’s comprehensive credit reporting system means that your credit file now contains details of your monthly credit repayments over the past two years. In other words, positive and negative information is included, so having a history of making on-time repayments can improve your borrowing capacity in the eyes of a lender.
For people who don’t have a credit file, taking on debt can help you build up a credit score so that you can qualify for larger credit amounts in the future. For example, by switching to a postpaid mobile phone or applying for a low-cost credit card, you’ll be able to build a credit history that shows you’re a reliable and trustworthy borrower. This will then boost your borrowing power when you need to apply for a larger loan, for example, a home loan, in the future.
Does the type of debt matter to the lender?
Your credit file also contains details of the type of credit accounts you have applied for or opened, as well as the name of your credit providers and if they have a credit licence. With this in mind, the type of debt you apply for or take on can have an impact on how a lender views your credit file.
For example, applying for a home loan from a reputable bank will be viewed in a more positive light than if you apply for credit from a payday lender. Your lender may also give more weight to your history of making on-time repayments towards a home loan than they would if you were paying off a short-term loan.
Improving your credit score
While debt can be good or bad, any type of debt can have an adverse impact on your credit score. The key is to know when debt starts to negatively affect your credit file – if you’ve taken on more than you can comfortably afford to repay and have started to fall behind on repayments (or worse), your future borrowing power will be significantly reduced.
However, from reviewing your credit file to consolidating debt, there’s plenty you can do to improve your credit score and get your finances back on track.