Holiday Debt and Credit Scores
However, good intentions can lead to bad outcomes. Therefore, it’s important to understand how the debt from your holiday shopping spree will affect your credit score. After all, holiday gifts are intended to create memories that will last a lifetime, but your credit score will shape your life and celebrations for years to come.
How Does Debt Affect Credit Scores?
One of the first steps in understanding how to fix your credit is understanding how debt affects your credit score requires that you understand how the credit reporting agencies evaluate debt. There are two main categories of debt, revolving debt and installment debt. While you are responsible for paying back each kind of debt, the credit reporting agencies measure and evaluate them a bit differently.
Installment debt generally takes the form of loans. The loans are for a fixed amount of money, and you make payments to reduce the balance that you owe. Installment debt is generally seen as an investment in the future. It includes things like student loans, car loans, and mortgages. Installment debt starts out at the maximum amount of debt you’ll have for that product, and goes down as you make payments. This is in contrast to revolving debt, as we’ll see in a second.
Revolving debt is the kind of debt that people typically use to make holiday gift purchases. It includes credit cards and credit lines at specific stores or companies. For example, if you are approved for up to $5,000 in financing for a computer for a computer company, then you spend $2,000 on a new computer, you’ll be using 40% of your available credit on that line.
It’s important to understand this aspect of revolving debt. Credit reporting agencies look at what your credit limits are versus how much credit you’re using. This is known as your credit utilization. Generally speaking, you want to keep your credit under 25%. Therefore, if you have a credit card with a $10,000 limit, and two store credit lines with $5,000 limits, you’ll want to be using less than $4,000 across all of your accounts to avoid a harmful effect on your credit score.
Revolving debt isn’t viewed the same way by credit reporting agencies because it isn’t an investment in future growth. Instead, revolving debt is a burden that you’re obligated to pay and nothing more. That’s why credit reporting agencies look at how much of your revolving credit you’re using. The greater the percentage of your revolving credit you’re using, the greater the odds that you’re living beyond your means. Therefore, there’s a greater chance that you’ll have problems making payments on future credit and loans you take out.
Debt to Income Ratio
The next important consideration for understanding how holiday impacts your credit score is your debt to income ratio. This ratio consists of the total amount of money you owe across all accounts as compared to your income. The greater your debt to income ratio, the more problems you’ll have paying off your debts on time.
Holiday shopping can greatly affect your debt to income ratio if you’re not careful. This measurement tells credit reporting agencies and lenders how long you’ll take to pay your debts off, and how much trouble you’ll have if you face unforeseen complications like an accident or medical bills. Someone with a lower debt to income ratio will have an easier time recovering from these unforeseen expenses than someone with a higher debt to income ratio. Therefore, you need to be careful regarding how much you spend on holiday gifts so that the debt you accumulate does not dramatically tip the balance of this relationship.
The final thing to consider when you’re learning about how holiday gift spending can impact your credit score is your ability to make payments. All too often consumers get caught up in the idea of giving the perfect gift or gifts and fail to consider how the debt they’re incurring will get paid back.
One of the most important things to keep in mind when you’re shopping for holiday deals is the interest rate you’re paying. For example, if your credit card charges a 15% interest rate, then putting an item on your credit card which is on sale for 10% off doesn’t actually produce the savings you’re expecting on that purchase. Failure to factor in the interest rate you’re being charged for your purchases can produce a huge surprise when you get the bill from your holiday shopping.
Sometimes consumers spend a certain amount of money and plan to pay that amount back, but with interest rates the amount they’ll need to pay might be 10-20% higher than they’ve planned. As a result, they carry a balance over to the next payment cycle. This increases the amount of your revolving credit you’re utilizing, which can lower your credit score and make it harder to qualify for or get favorable terms on loans and lines of credit in the future.
The best way to ensure that your credit score isn’t affected by holiday shopping is to make your regularly scheduled payments on time. Making on time payments will help to increase your score by showing creditors that you are a reliable consumer who understands how to use debt and credit responsibly. However, late or missed payments will dramatically reduce your credit score, as they serve as a red flag to creditors and lenders that you will be a risky investment.
The best way to handle holiday shopping is to not go into debt at all. If you have to use debt to complete your holiday shopping, be sure to keep the interest rates in mind, and make sure you’re not taking on more debt than you can pay off. If you follow these guidelines, then your credit score won’t be hurt by your holiday gift buying.