Too Much Debt is Bad for Your Credit

Did you know that having too much debt can have an adverse affect on your credit rating? It's true. Even if you always pay your bills on time, having a high amount of debt can drop your credit score and having a lower credit score can hurt you if you need a mortgage. When you apply for a loan, lenders pull your credit to find out how risky a borrower you are. The higher your credit score, the less of a risk you are to lenders and the better loan you'll be able to get.

Lenders also look at something known as your "debt-to-income ratio" which is the ratio between how much debt you have to the amount of income you make. So, for example, if you make $50,000 and you have $10,000 in debt (credit cards, personal loans, etc.), your debt-to-income ratio would be 20 percent.

The Federal Housing Administration (FHA) requires that your monthly mortgage payment combined with your non-housing debts do not exceed 41 percent. Unfortunately, the credit reporting bureaus don't reveal how they calculate credit scores, so it's hard to say exactly how much debt is too much. But if your debt-to-income ratio exceeds 41 percent, it's too much.

Raise Your Credit Score

Many people mistakenly believe that if you have too much debt, closing your credit card accounts will help raise your credit score. This may actually have the opposite effect and lower it even more. Closing an account does not remove it from your report and the debt (unless paid off) would still appear on your credit report. It's also a mistake to move your credit card debt from one card to another, since this does not reduce the amount of debt you have.

The way to start raising your credit score is to pay off your debt. You still need to keep some revolving debt and to keep paying your bills on time to prove that you are a trustworthy borrower. The trick is to find the "sweet spot" --the point at which you don't have too much debt and yet can still maintain a good credit score.

If you're buying a home or looking to refinance your mortgage, take some time before you do so to pay off as much debt as you can. Raising your credit score can help you qualify you for a lower interest rate, and thus a lower monthly mortgage payment.