Bad credit could mean the difference between getting a prime loan and suffering through unfavourable loan deals or getting your loan application denied outright. As such, having a good grasp of what it entails can help you avoid it or repair it.
Defining bad credit
The term “bad credit” suggests that a person has an unfavourable credit rating. This is based primarily on your credit history, which is an account of your past liabilities and repayments. Failure to manage credit properly in the past affects your current credit worthiness to different degrees and for varying periods.
Factors that damage your credit standing
Poor financial management practices lead to bad credit. Lenders deem persons who have the following in their credit history to be “high-risk borrowers”.
♦ Late payments on a regular basis
♦ Filing for bankruptcy
♦ Skipped payments
♦ Exceeding credit card limits
♦ Tax liens because of non-payment of property taxes
♦ Judgments against you arising from non-payment of debt
Why identifying bad credit is important
Financial institutions are wary about lending money to those who are not likely to repay the debt in a timely fashion. After all, they make their profit through interest payments gained by lending money and need to recoup many of the credit offers they make to stay in business. However, financial institutions would not have all of the required information of your past activities with other creditors. They rely on credit bureaus to provide a credit score that would indicate the degree of credit risk that you pose to them. Ultimately, your credit score is used as a decision tool to influence your credit offers and associated interest rates.
Defining the credit score
A credit score is a numerical representation of a person’s credit worthiness that financial institutions use to make a decision whether to offer a loan at standard or higher rates or to deny the loan application outright. There are a few systems for calculating credit scores and you can now get free credit reports, unlike times past when you had to pay credit bureaus for them.
The main system used for credit scoring is the FICO (Fair Isaac Corporation) system. The primary factors used to determine your credit score include:
Credit utilization (debt/income ratio)
Length of credit history – a longer credit history makes your credit score more reliable
Types of credit you utilized – For example, whether you used consumer loans or mortgages
Your credit score, according to the widely used FICO system, is a number between 300 and 850; higher numbers represent better creditworthiness. The FICO score is popular because it utilises the information from all major credit bureaus. In the Unites States, the three major bureaus are Equifax, Experian and Trans Union.
The link between your credit score and bad credit
Bad credit scores are usually defined by a specific range. You should note that what is “bad” can differ among financial institutions and depend on what you are applying for. Generally, a FICO credit score between 500 and 580 represents bad credit to most lenders. However, if you are applying for a home loan or mortgage, the credit rating is more stringent. For home loans, a FICO credit score below 620 is considered bad credit.
While a score above 620 is not considered bad for a home mortgage offer, the interest rate is where a score of 625 is far less favourable to a score of 650. According to www.myfico.com , the difference in a monthly payment for a 30-year fixed mortgage between someone who has a 760-850 score and someone who has a 620-640 score is a whopping $292.00. Anyone with a credit score below 620 would need a sub-prime mortgage.
For shorter term loans, there is a bit more leverage in defining bad credit. For instance, some with a score between 500 and 589 would get a credit offer for a car loan, but at an APR of 18.81%. An excellent credit score yields a favourable APR of 4.94% for the same loan – all other things being equal.
While there is no absolute “bad” score, credit scores below 620 limit your options significantly and can be considered bad for that reason only. However, average credit scores are not good because, while they allow offers, the offers have high interest rates attached because you still pose a credit risk to the lender. Good credit would have lenders competing for your business; you can choose the best offer. Bad credit leaves you desperate for a deal, with either no offers forthcoming or unfavourable offers with extremely high interest rates.