December 24th, 2008
No Debt Does Not Mean Good Credit
For many US consumers, it is a common misconception that if you have no debt then you must have good credit. Several of our members write comments with that assumption every week or ask if the system is broken because their credit score is not excellent even though they carry no balances.
The simple answer is that debt is only one component of the credit scoring system. (There are over 200 variables that go into your credit score.) You have to remember that a credit score is supposed to tell lenders how likely you are to default on a loan. If you have no debt, you are probably less likely to default, but from a statistical perspective, you are even less likely to default on a loan if you have no debt and you have had access to large amounts of credit for a long time.
That is the simplest of reasons why credit scores are not necessarily tied to debt. With that said, carrying too much debt is definitely a bad thing as it could affect your ability to pay them all back. If you have no debt and want to improve your credit score here are a few tips:
- Have Credit Cards. Consumers with good credit have 3-6 credit cards on average. If you need additional cards, make sure you apply for no annual fee credit cards. Having and managing your access to credit responsibly is an easy way to show lenders that you do not abuse credit and that you can pay bills on time.
- Use Your Credit. It generally does not make sense to pay interest or fees just to boost your credit score, but using your credit cards regularly and paying in full helps develop a histoy of on-time payment. Buy a tank of gas once a month or use your credit to pay for groceries, pay your bill in full and build your credit profile with positive activities.
- Use Different Types of Credit. Credit is a great thing if used responsibly. Auto loans, mortgages, and home equity loans are another way to help build your breath of credit experiences. Now don’t get one just to increase your score but realize that it is not bad to have these types of tradelines on your credit report.
- Have a Long Credit History. Keep your oldest credit card account open assuming there are no fees. A long history of credit is a great way to show lenders that you are responsible with your credit.
Share your thoughts about this topic.
Ken, first of all, thanks for a great site!
I thought I was pretty savvy financially, but this is myth that I fell for. I’ve been pretty much debt free for the last five years and my score went up a bit, then fell when I stopped carrying a balance! I think I’d better use my cards occasionally just to keep them active and reporting.
I do have a question, though. Paid off the mortgage recently. When will my good payment history on that fall off the reports (dread seeing the score plummet then!)
Rather than give you an educated guess, I’ll have to look into the specifics of your question.
Regardless, don’t be concerned about your score a taking a major hit. Breadth of tradelines is a minor component in credit scoring. Long history, good standing, and some activity are the big factors.
It is my understanding that accounts that were in good standing and paid in full should remain on your credit report. I’ve never personally had a mortgage account on my credit reports but I have several other term and revolving accounts that have remained on my credit report(s).
I both agree with you and disagree with you. I agree about your statement “but from a statistical perspective, you are even less likely to default on a loan if you have no debt and you have had access to large amounts of credit for a long time.”
I disagree somewhat about the credit card. While you are 100% correct in using a credit card will increase your credit score – I disagree in the fairness and the overall conclusion about people who don’t use credit cards. I propose that the Visa debit card makes regular credit cards obsolete for people who have money in the bank. The Visa or Master Card debit card does everything a credit card does except you don’t have to send in a check at the end of the month and waste a stamp. The Visa debit card is not part of your credit score and it should be. In the old days a finance company would call up your bank and get an idea of how much money you had in your account. The bank would say a low 3 figure or maybe a middle 3 figure amount. (My wife use to work for Beneficial Finance) My point is that we have gotten away from assessing people’s credit based on their net worth and instead on how they utilize one bad credit product, the credit card. That is not fairness.
I can certainly understand your point. Our article was not about fairness but merely the state of the industry and how credit scores work. To expand on your perspective, there are companies who believe your payment history on utilities and rent are also indicators of your creditworthiness.
Right or wrong, today’s standards don’t take those attributed into account. As for the debit card argument, while it might be a good indicator of responsibility, it may not be a good indicator of risk since you are not truly building any experience in using “credit”. A debit card is analogous to an electronic check book.