According to recent surveys, approximately 30% of Americans have a FICO credit score lower than 649. Because this percentage represents millions of people, the side effects of bad credit are something most Americans should be aware of.
The term “bad credit” indicates that a person has a low credit score, which could happen due to a variety of reasons. Whether this low score was caused by late payments, bankruptcy, high credit utilization ratios, or insufficient credit experience, bad credit can affect many areas of a person’s life, including their ability to rent an apartment or even their employment opportunities.
The information in this article will hopefully help you understand some of the most important details about credit scores, how lenders use them to assess your credit situation and the negative effects of bad credit on your day-to-day living.
How are Credit Scores Calculated?
Credit scores are a tool that helps creditors and lenders quickly assess a borrower’s creditworthiness. They are calculated through a combination of different variables related to the person’s credit situation, including past credit history, length of credit accounts, and credit mix. Each of these elements is assigned a weight, and the higher the weight, the bigger the impact a variable will have on the overall calculation.
In the U.S., the FICO score is the most popular credit score. This scoring tool was created by the Fair Isaac Corporation to estimate a person’s creditworthiness based on five different variables. The FICO score can range from 300 to 850, with 300 being the lowest score a person can get and 850 being the best credit situation possible.
The information used to calculate these scores is usually obtained from credit reporting agencies (CRAs), also known as credit bureaus. These institutions process millions of credit-related transactions made by consumers daily. They organize the information to show the overall details of the credit accounts held by each person, the amount owed, the maximum credit limit granted, the age of the credit account, and any other relevant details that are used by scoring tools such as FICO, to estimate an individual’s credit score.
In the United States, three major credit bureaus (Experian, TransUnion, and Equifax) process the financial information of more than 200 million Americans.
Lenders have also incorporated other credit scoring models separate from FICO to integrate other variables that FICO may be leaving out, or to rearrange the weights assigned to the different variables assessed by the FICO model.
Some of these alternative scoring tools are VantageScore, TransRisk, developed by Transunion, and the Experian National Equivalency Score. Additionally, FICO itself has different scoring models apart from the widely employed scoring model used for most types of loans. These models are designed for certain types of loans, including a customized auto loan scoring model and a mortgage scoring model.
Since the FICO® score is employed by most financial institutions, let’s look into the five variables this scoring model incorporates to determine a person’s credit score.
Credit History
A borrower’s credit history consists of all their credit accounts, along with a detailed summary of each of the installments and payments made during the lifetime of each account. There are many different statuses associated with each account, and they are assigned based on the situation of the financial obligation. The most common statuses are “current” or “paid as agreed,” “X days past due,” “closed,” or “charge-off.”
This variable has the largest weight (35%) in the calculation of FICO scores. Negative items such as late payments, accounts in collection, or bankruptcy filings will negatively impact the score, and, therefore, they should be avoided.
Amount Owed
The total amount of Personal debt is the second-largest variable evaluated by the FICO scoring model, and it reflects not just the amount of the overall debt, but also the relative portion of that amount compared to the maximum credit limit extended by lenders. This ratio is known as the credit utilization ratio, and it indicates how much of the available credit limit the borrower is currently using.
With a weight of 30%, a high utilization ratio will negatively impact the overall score. FICO analyzes both the overall and individual account credit utilization ratio to analyze this variable, and credit experts tend to recommend a ratio lower than 30% to improve your score.
Age of Credit History
Yes, a person’s credit history has an age, and the older it is, the better the result you’ll get out of this variable. The age of your Credit history is usually determined by the average number of years that you’ve held your credit accounts. Accounts in good standing that are five years old or older will positively impact the overall score as they add up to your credit experience.
In turn, a person who has accounts that are younger than 3 years will usually get a lower score on this variable as they have fewer years of credit experience. This particular variable is assigned with a weight of 15%.
Credit Mix
The FICO scoring model also values a person’s credit experience based on the different types of credit accounts they hold. Some of the most common accounts include mortgages, car loans, installment loans, credit cards, utility bills, and phone bills, among others. A good standing on each of these accounts will help to increase this variable’s score.
The credit mix of an individual has a weight of 10% on the overall credit score calculated through the FICO model.
New Credit Accounts
FICO analyzes any new credit applications submitted during the last 12 months by looking at credit inquiries your report has received. These inquiries are generated every time a lender requests your credit report, and the accumulation of too many inquiries too quickly will negatively impact this variable.
Even though you may have significantly older accounts in good standing, new accounts will impact your overall score either way. The impact can be either mild or considerable, depending on the score of the previous variables. This element affects 10% of a person’s score.
The term “bad credit” indicates that a person has a low credit score, which could happen due to a variety of reasons. Whether this low score was caused by late payments, bankruptcy, high credit utilization ratios, or insufficient credit experience, bad credit can affect many areas of a person’s life, including their ability to rent an apartment or even their employment opportunities.
How Do I Know What My Credit Score Is?
According to the Fair Credit Reporting Act (FCRA), credit reporting companies that operate in the United States must provide each consumer with a free annual credit report. This credit report will disclose all the credit information that each of the largest three credit bureaus has compiled, and they cover a 12-month period.
Additionally, if you need to access an updated report in between that 12-month period, some paid services allow you to do so. They also offer some extra features — like credit monitoring and credit alerts — that can notify you if a new negative item is added or if new credit accounts show up. These features are valuable to identify if your identity has been stolen, or if someone has been applying for credit on your behalf without your consent.
How Do Credit Scores Assess a Borrower’s Creditworthiness?
Financial institutions use the Fico score, or any other scoring model, to quickly assess a borrower’s creditworthiness. The score reflects the person’s credit situation, even though it doesn’t paint a detailed picture.
While it is not the only element lenders consider when they analyze a credit application, traditional lenders usually set a minimum credit score for a person to be considered a suitable candidate for a personal loan.
The FICO model categorizes the potential creditworthiness of consumers on five different scales, depending on their credit score. These scales serve as a guide for most lenders, along with other variables, to make decisions regarding the applications they receive from consumers.
Traditional lenders may reject applicants with scores under 670 to mitigate their risk. Even though a credit score of less than 670 doesn’t indicate that a borrower is unable to fulfill their commitments, it does indicate that the borrower has failed to pay for their financial obligations on time in past situations. This fact, along with other negative aspects associated with the rest of the variables used to calculate the score, will potentially impact a borrower’s chances of being approved for a loan.
On the other hand, having a score of 670 or higher doesn’t guarantee that a borrower will be approved for a loan. Most lenders incorporate other variables into their assessments. All in all, credit scores are an important tool used by lenders to determine the creditworthiness of a borrower, but they are often accompanied by another set of requirements of a similar or different nature. One example would be the demand for collateral as a mandatory requirement to approve a new credit account.
What Are the Negative Effects of a Low Credit Score?
The potential struggles to get approved for a Line of credit with most financial institutions is not the only side effect of a bad credit score. Other aspects of your personal finances and your day-to-day living may be affected by low scores.
Higher APRs on Your Variable-Rate Loans
The agreement of variable interest rate loans may include a clause that allows the lender to increase the interest rate associated with the loan if the credit situation of the borrower deteriorates at some point during the lifetime of the financial commitment. In this sense, one of the negative effects of a bad credit score would be that borrowing costs (past and future) can be increased.
Phone Companies May Not Extend you a Contract
A bad credit score can force you to prepay your phone expenses as telecommunication companies check your credit score to decide whether you are eligible for their plans.
Higher Insurance Premiums & Higher Costs of Financing
Car and home insurance premiums may be affected by a bad credit score. Even though the risk of a crash is not at all associated with a person’s credit situation, insurance companies have linked low credit scores with a higher frequency of claims. Therefore, individuals with bad credit must usually pay higher premiums. Also, the cost of financing your insurance policy will probably be higher.
Finding a Place to Rent May be More Expensive
Renting an apartment involves a commitment with a landlord to pay rent on time. Most people who offer properties for rent will look through your most recent credit report to get a sense of how responsible you have been with your previous financial commitments. This doesn’t mean that individuals with bad credit won’t find any place to rent, but the rent may be increased due to the additional risk associated with a bad score.
Employment Opportunities May Be Affected by Bad Credit
Employers can’t really see a person’s credit score, but they can get limited access to their credit reports. Credit agencies usually provide a customized product for employers who want to know more about their current or prospective employees, and these tailored reports usually contain personal information (granted with the employee’s consent), along with details of publicly available credit information, such as bankruptcy filings and judgments.
Some employers have policies that screen out applicants who are going through some of these proceedings, and, therefore, negative items on a credit report can affect a person’s employment opportunities to some extent.
Low-Limit Credit Lines
Some traditional lenders may be willing to extend lines of credit to individuals with low scores. However, considering the risk associated with those loans, lenders usually limit the amount of the loan to a maximum of a few thousand dollars. Because of this, a bad credit score can affect the credit limit of new credit accounts.
Is It Possible to Increase Your Credit Score?
Credit scores can be modified over time, depending on how the borrower’s situation evolves. Typically, credit reporting agencies incorporate new items, changes, and modifications to credit accounts a few weeks after they have occurred. The overall impact of these changes will depend on how each one modifies the corresponding variables mentioned above. The variables with the most weight will have the most impact, specifically an individual’s payment history and the total amount owed.
Some short-term favorable moves you can make to improve your credit score are:
- Lower your credit utilization ratio by paying off some of your current debt.
- Stop applying for new credit cards if you don’t really need them right now.
- If you have a spouse or a close relative with credit accounts in good standing, they can sign you up as an authorized user (AU) of their accounts. Your credit report will incorporate their credit experience, and you’ll benefit from their positive status.
- Don’t close old credit cards just because you don’t use them. The older they are, the better, and if you are not using them right now, that’s even better as they are lowering your utilization ratio.
- Ask the credit bureaus to incorporate some non-traditional credit accounts, such as your rent payments or utility bills. If these accounts are up to date, you’ll benefit from their incorporation.
The best way to build up a solid credit score is to consistently maintain healthy financial habits, which will produce good results over the long term. Some of these habits include:
- Do your best to pay your bills on time. Set up automatic payments if you tend to forget your due dates, and try not to take loans you can’t afford to pay at the moment.
- Use your credit cards and lines of credit only when necessary. Just because you have them doesn’t mean you have to use them. Maintaining a low utilization rate is important to achieve a higher credit score.
- Be careful with consumer credit. Some stores may offer benefits to enroll you on their consumer credit lines, but those tend to produce credit inquiries, and new accounts will ultimately reduce your score. If you already have credit cards you can use for the same purpose, consumer credit is not always necessary.
Nevertheless, there are some important details you should know about credit account statuses:
- Current open and paid-as-agreed accounts will stay on your report indefinitely.
- Late payments, collections, charge-offs, and chapter 13 bankruptcies, among others, will stay on your report for seven years.
- Chapter 7 bankruptcies will show up on your credit report for ten years.
Is it Possible to Get a Personal Loan If You Have Bad Credit?
As we previously discussed, bad credit scores negatively affect your borrowing capacity, the costs associated with the personal loans you apply for, and even your ability to rent a home. Nevertheless, there are still alternatives you can consider if you want to apply for a personal loan.
CreditNinja offers its clients a wide range of loans designed to suit their unique financial needs. Our bad credit loans were conceived to help people who are temporarily struggling with difficult credit situations by granting them access to alternative loan options.
