Three Type of Debts and how they affect your Credit Score

“Too many people spend money they haven’t earned, to buy things they don’t want, and to impress people they don’t like” – Will Smith

Your debts are the total value of everything you owe. Debts are the most savage kind of liabilities because they take out money from your bank with high interests. According to Warren Ingram, the author of Become your own financial adviser, the state of owing money is the biggest trap for wealth, and most of the world’s savvy investors have avoided debt at all costs.

Whatever situation you find yourself in, always do your homework before you opt for a loan or anything that will incur debt under your name. Failure to handle debt negatively affects your credit score.

Your credit score is a three-digit number that tells creditors how much debt you currently have and how you have handled credit in the past. This number range from 0 to 999; 0 is the worst score you want and it probably mean you are bankrupt or blacklisted.

You should always aim for a credit score greater than 730 because anything below that can put you on the wrong side of the creditors.

Factors that influence your credit score includes your account information, payment history, amounts owed and any default. Credit score shows whether you are credit worthy and whether you will be able to meet your financial obligation. To be on the safe side, avoid paying your debts late or not making full payments.

Most importantly, familiarize yourself with the following three types of debt because your financial well-being hinges on them.

1.    Short term debt

Short-term debt is categorized as bad debt. The challenge with bad debt is that the annual interest rates are so high (from 18 – 22%) and you could end up paying almost double the amount of the initial loan that you took if you are not careful. The period for short-term debt, normally range from six to 24 months but credit cards debt can be longer.

This debt is used to purchase consumable items or anything that will lose value and not generate income. The exception could be a personal loan, provided the loan is used to buy capital generating assets or to start a business. However, most financial advisers do not recommend this approach as 90% of business start-ups end up in failure.

Short-term or bad debt includes overdraft, credit cards, store card debt like clothing accounts, personal loans and hire-purchase agreements. Most people believe having debts will help them build a credit score while others do it just to keep up with the Khumalo’s.

Several factors come into play when building a credit score. Missing or not paying your premiums or debt in due course negatively reduce your credit score. Always ensure before you take out a loan that you can afford it and mostly importantly, you are aware of the implications that comes with annual interest rates of that debt.

The second factor involves the age of your account. Credit cards and personal loans must be avoided due to their exorbitant interest rates. However, store cards and at affordable limit can help build your credit score if you pay the full amount and on time (ideally, aim for less than 10% of your earnings). At the end of your credit period, you can renew the credit to boost your credit history, which also improves your credit score.

2.    Medium term debt

Medium term debts are also referred to as neutral debts. This type of debt is incurred when taking a loan to purchase a vehicle for over 54 to 60 months (About five years) financing period. Depending on the type of vehicle you purchase, medium-term debt can be an asset or liability, hence it’s referred to as neutral debt.

For instance, if you buy a truck or bakkie for business purposes or even a small vehicle to join transportation platforms like Uber or Bolt, your vehicle can be an asset. However, if it is for personal use, it is a liability. Generally, you should never spend more than 20% of your monthly earnings on repaying a car debt and that includes petrol, insurance and maintenance costs.

Moreover, vehicle debts are neutral if the buyer can afford and pay off the loan quickly before the prescribed period. No matter what financial situation you find yourself in, never finance a vehicle with a balloon payment or residual. This is when you are required to pay a lump sum at the end of your vehicle finance period. If possible, buy your car cash or start with 50% deposit up front.

Remember not to miss your monthly car instalments or insurance premiums, and when you pay, always ensure you are paying in full. Otherwise, your credit score will be negatively affected.

3.    Long-term debt

Long-term debts can be referred as good debts since they are mostly home loans. These are assets that are able to generate an income and have the potential to increase in capital value, too. Home loans are mostly issued by banks to help people buy a home with expectations to pay off that loan over a 20-year period or less.

Caution: “Home life ceases to be free and beautiful as soon as it is founded on borrowing and debt.” – Henrik Ibsen

This can be a good debt because a home can appreciate in value and maintain its worth against inflation. This means you might generate a profit when you decide to sell your house provided your debt repayments small enough and the running expenses have been settled.

In a nutshell, there are instances where you can use debt productively, but you need to be careful and treat it as necessary evil to purchase assets that will generate income for you. Remember to pay your debts on time and in full, and whenever possible, more than what is due to you so you may pay off the debt quicker.