The Horrifying Truths About The Impacts of Consumer Debt on Credit


The Horrifying Truths About The Impacts of Consumer Debt on Credit

October 24, 2023
Certified Credit

This year, consumer debt reached a staggering $17.06 trillion. This spike in consumer debt can be attributed in large part to inflation. With so many products and services costing more, many Americans simply don’t have enough money at the end of the month to make ends meet. As a result, many are relying on credit cards and loans to bridge the gap. 

With consumer debt skyrocketing, you may be wondering about its credit score implications. So, how does consumer debt affect credit? And what can consumers do to protect their credit scores? 

In this article, we’ll explain the impact of rising consumer debt on credit scores. We’ll also provide some suggestions for managing consumer debt responsibly. 

Consumer Debt in 2023: By The Numbers

To start, let’s review some noteworthy statistics about the current state of consumer debt. According to a Q2 2023 Federal Reserve report:

  • Credit card debt climbed to $1.03 trillion, reaching its highest level in recorded history.
  • Other consumer loans and retail credit cards saw a quarterly increase of $15 billion.
  • Auto loan balances increased by $20 billion, bringing them up to $179 trillion.
  • Credit cards’ average interest rate has reached a whopping 20.53%.
  • Interest rates reached a 22-year high, causing revolving debt to be that much more expensive.

While debt balances are on the rise, delinquency rates have stayed relatively low since their sharp decline during the pandemic. Credit card delinquencies have only increased by 0.7%, while auto loan delinquencies have increased by 0.4%.

Low delinquency rates suggest that households with consumer debt aren’t facing financial distress just yet. After all, the job market is still going strong and wages are rising. But if the economy takes a turn for the worse, these record-high rates of consumer debt could present some pressing challenges.

How Does Consumer Debt Affect Credit

Consumer debt and credit scores are closely related. Consumer debt impacts three of the five major credit scoring factors: payment history, credit utilization, and new credit inquiries

Let’s take a look at each of these factors in greater detail:

#1 Payment History 

Payment history is worth 35% of consumers’ FICO credit score. Consistent, on-time payments help establish positive credit histories, while late payments can negatively impact credit scores for up to seven years. 

So, how does consumer debt affect payment history? It ultimately depends on how you manage your consumer debt. If you always make your payments on time, consumer debt can bolster your credit score. But with outstanding debt balances on the rise, monthly debt payments are increasing for many people. If your debt payments become unaffordable, making on-time payments may become a challenge. 

If you become delinquent on your debt payments, you’ll likely see a sudden drop in your credit score. If your missed payments get out of hand, you may even need to file for bankruptcy at some point. A bankruptcy can harm your credit score for up to ten years

#2 Credit Utilization

After payment history, credit utilization is the second most impactful factor in the FICO and VantageScore credit scoring models—it makes up around 30% of your credit score. Credit utilization compares your total revolving credit balance to your total credit limit.

When it comes to the stark rise in consumer debt, credit utilization is impacted most directly—as consumers’ debt balances increase, so does their credit utilization. 

Having a credit utilization ratio over 30% can hurt your credit score. That’s because a high credit utilization suggests that you may be relying too much on credit to get by.

What If You Pay Off Your Credit Cards?

If you have large credit card balances, the best thing you can do for your credit utilization is to pay them down. There are many methods you can employ to tackle your debt, including the:

    • Avalanche method – With the avalanche method, you pay down your debts in order of their interest rates, starting with the highest interest rate balance first. By doing so, you can set yourself up to save the most amount on interest, and therefore, expedite your debt repayment process.

    • Snowball method – The snowball method takes a different approach. Rather than going by interest rate, you pay down your credit cards in order of their balance sizes, starting with the smallest balance first. This method allows you to achieve success early on in your debt repayment journey, which may help you maintain your motivation as you go on to tackle larger credit card balances down the line.

    • Debt consolidation method – If you have several credit cards, keeping up with multiple payments can be a challenge. By consolidating this debt using a personal loan or balance transfer credit card, you can transfer all of your debt to one account and make one, easy payment each month.

      Ideally, your new credit account should come with a lower interest rate than your current credit cards. Many balance transfer credit cards come with 0% APR introductory periods. If you can pay off your entire balance within this time, you can save a ton of money on interest and get out of debt faster. 

Be Strategic About Closing Credit Card Accounts

While paying down your credit card balances can enhance your credit utilization, you need to keep one thing in mind: if you close a credit card account, its credit limit will no longer factor into your credit utilization equation. Thus, paying off a credit card and closing it could end up harming your credit utilization in some cases.

Consider a consumer who has three credit cards with the following credit limits: $1,000, $2,000, and $2,500 (making up a total credit limit of $5,500). The outstanding balances on these credit cards are $500, $1,000, and $1,700, respectively (leading to a total balance of $3,200). This consumer’s credit utilization is 58% ($3,200/$5,500), which is well above the optimal limit.

Let’s say this consumer gets serious about paying down their debt and employs the snowball method. After paying off their $500 credit card balance, they closed the account. This causes their outstanding debt balance and credit limit to drop to $2,700 and $4,500, respectively. In turn, their credit utilization increases up to 60% ($2,700/$4,500). This example showcases why you should keep old credit card accounts open, even after you pay them off.

#3 Consumer Debt’s Effect on New Credit Accounts

FICO and VantageScore both take into account recent credit inquiries. In other words, applying for new credit can bring down your credit score by a few points temporarily.

If you’ve applied for new credit cards or loans to leverage more consumer debt this year, your credit score may be lower as a result. Fortunately, its drop should be relatively small and short-lived. 

Consumer Debt’s Far-Reaching Effects

Consumer debt can impact many facets of your creditworthiness, but its consequences don’t end there. Consumer debt may also result in a:

  • Loss of savings – As consumers spend more on monthly debt payments, they have less money to set aside. Without well-funded emergency savings and retirement accounts, many consumers may find themselves years behind where they want to be financially.

  • Contracting economy – As savings suffer, so may discretionary spending. Many consumers are already cutting back on eating out, vacations, and other non-essentials. If this trend continues, the looming recession may become a reality sooner rather than later.

  • Personal problems – While debt has financial effects, both personally and societally, it can also affect your health and relationships. According to a LendEDU survey, 56% of participants have lost sleep over their credit card balances. Meanwhile, nearly 39% of respondents said their consumer debt has caused tension in their relationships with friends and family. Beyond that, credit card debt has caused 42% of respondents to put off purchasing a home, 30% to postpone starting a family, and 26% to delay getting married. 

How to Assess Your Consumer Debt

Consumer debt may be skyrocketing across the country, but you don’t need to fall into this trend. Here are some ways to keep your consumer debt in check:

  • Calculate your Consumer Leverage Ratio (CLR) – CLR compares your total monthly consumer debt to your monthly disposable income. If your CLR is above 20%, you should seriously consider paying down your debt.

  • Make debt repayment a priority – If you’re carrying large credit card balances, paying them down as soon as possible can set you up for better financial outcomes. You can pay down your debt using any of the methods we mentioned above.

  • Monitor your spending – Whether you want to pay down your debt or prevent incurring more of it, you need to take a critical look at your current spending. Map out where your money is going each month and see if you can cut back on certain categories. By spending less, you’ll have more money to put aside for debt payments, savings, and investments. 

Get More Credit Education From Certified Credit

In summary, consumer debt is posing a real threat to consumers’ personal finances and the economy at large. The only way out of this predicament is for consumers to get informed about their debts’ implications and make savvy credit decisions going forward. 

If you want to learn more about credit, check out Certified Credit’s blog. As a leading mortgage credit report provider, we share educational resources about credit scores, mortgage loans, and the home-buying process.