One of the questions I get asked most frequently is ‘How did you pay off your debt?‘ Because let’s face it: paying off over $25,000 in three and a half years, and the final $18,000 in just ten months, is pretty impressive. Especially on my tiny income of less than $32,000.
When people hear that story, a couple things happen. They think that I was supported in some way (like living at home for free), or they think that I cracked some sort of debt code. That I discovered the secret money management sauce that I poured all over my life and it washed away my debt.
The truth of the matter is that I became a debt ninja. I immersed myself in it full time. I learned everything I could about debt and credit, and I was completely dedicated to eradicating my debt from my life. That dedication meant that I saw big results month after month, which in turn cut down on my payoff timeframe.
It’s not over the top to say that learning about my debt changed my life. So let me beak down the two most common types of credit out there for you and how it affects your debt, so that you might become a debt ninja in your own right.
The Relationship Between Debt + Credit
First things first. Let’s explore the relationship between credit and debt.What does these words even mean? Here’s a quick breakdown of some of the most frequent questions people have about these bad boys.
Are they the same thing? Nope! Sometimes they are used interchangeably, but these are two different things.
Can you hit me with those definitions? Sure!
Credit is the amount of money you are allowed to borrow from a lender. You’ve probably heard the term ‘credit limit’ before. Well, that means you have the ability to borrow money from a lender up until that limit number. Credit is money you haven’t yet borrowed but that you have access to.
Debt is the amount of money that you owe a lender. You’ve swiped your credit card, or taken out a student loan, and now you have to pay that back.
Credit and debt are closely related, and knowing about one helps your relationship with the other. Your available credit, debt amounts, length of credit history, and debt payment history also affects your credit score. Your credit score in turn affects things like interest rates you qualify for, or how much of a mortgage you can get.
Money is a never ending circle! Knowing these things about your money means you can take control of it.
Knowing the difference between debt and credit is great. Now let’s dive into the top two types of credit you’ll probably run across.
Revolving credit is the type of credit you have with credit cards or home equity lines of credit (HELOC loans). This means that you get a credit limit you can borrow against, and each time you pay it back, your credit is restored.
So say you have a credit card with a $5,000 limit. You spend $1,000 monthly, and when you make your payments, your credit limit goes back to the $5,000 all over again. You can endlessly have access to this credit, as long as you make at least your minimum payments.
Fixed Term Credit
Fixed term credit, also known as installment credit, is a line of credit from a lender that you pay back in fixed payments each month. How much money you owe and your interest rate were set when you were approved. Your total amount of credit never changes, and as you make payments the debt AND the credit disappear.
This is the opposite of revolving credit. Think of things like student loan payments or a mortgage. You borrow $250,000 from a lender for a house. You get a 4% interest rate, and you have a monthly mortgage payment of $1,600 a month. As you make those payments your debt drops, and your credit is not restored. Once you’ve paid back your mortgage you have no more credit with your lender.
What These Types of Credit Mean For Your Debt
Ok soooooo…how do these types of credit affect your debt?
So glad you asked! Because there are so many ways these two credit types can affect your debt!
Revolving credit can be a trap.
Revolving credit can be a quicksand of debt if you don’t manage it carefully. I’m sure you’ve heard credit card debt horror stories- people who can’t seem to dig themselves out of debt month after month.
Revolving credit, since it automatically restores itself, means it can create a cycle of dependence for it’s user. For those living paycheck to paycheck, credit is sometimes a necessity to paying all the bills. With your access to credit constantly refreshing itself, you can become hooked to a source of revolving credit.
Your interest rate can change.
Revolving credit accounts also often come with variable interest rates. A variable interest rate is something that can change at the lender’s discretion. So you can start with a 4% interest rate and get bumped to 5%.
To be fair, that can also happen with a fixed term credit. Student loans are a good example- some come with fixed interest rates and some don’t. The loan amount itself (of the amount of credit) doesn’t change, but your interest rate on it can.
About Your Credit Score
Both of these types of credit can affect your credit score negatively or positively. It all depends on how you use the credit.
Use revolving credit to boost your credit score by making on time payments every month, by keeping open older accounts (to show lenders you can be trusted long term), and by only using 30% of your available credit.
Maxing out your available credit each month is a red flag to lenders. They’re thinking ‘why does this person need so much credit?’ It makes you look shady, so don’t do it.
Use fixed-term credit to boost your score by also making on time payments and by paying off your debt in the appointed time. Missed payments are a huge no-no. They are the kiss of death for lenders. Lenders want their money back, so when you fail to do that it’s a problem.
Knowing about the types of debt and types of credit out there means having financial tools at your disposal. Knowledge is powerful! We can’t smash the system until we know what the system is.