Your credit score indicates how likely you are to repay your debts. Therefore, lenders use credit scores to determine whether to approve you for a loan. Based on the FICO score model (the most commonly used credit scoring model), lenders consider a credit score below 600 to be poor. If you have a bad credit score, lenders will consider you a “subprime” borrower who may have a hard time repaying any loan.
This guide explains the key aspects of bad credit.
How to Determine Bad Credit
TransUnion, Equifax, and Experian — the three national credit bureaus — each collects and maintains info for your credit report. They each use that information as well as the FICO (Fair Isaac Corporation) credit scoring formula in calculating your credit score.
The FICO score uses many pieces of data in your credit report, including:
- Payment history (35%): Lenders want to see if you have paid back other loans you owe in full and on time.
- Amounts owed/credit utilization ratio (30%): People with a lot of debt are deemed risky and less likely to pay off their loans.
- Length of credit history/age of credit (15%): Lenders like to see a long history of responsible borrowing.
- Types of credit in use/credit mix (10%): What type of credit you have; for example, mortgages and credit cards.
- New credit (10%): Taking new loans not only makes you a greater credit risk but can potentially lower your credit score.
Based on a calculation of these factors, a score of 300-597 means poor or bad credit.
The three major credit bureaus can also provide your credit score based on the VantageScore (another credit scoring model). Just like the FICO score, the VantageScore ranges from 300-850.
What makes the VantageScore different from the FICO score is the scoring factors and weights:
|Age and type of credit||21%||N/A|
|Age of credit||N/A||15%|
|Credit utilization ratio||20%||30%|
Based on the calculations of the VantageScore, a score of 300-600 means poor/bad credit.
“The three major credit bureaus can also provide your credit score based on the VantageScore (another credit scoring model). Just like the FICO score, the VantageScore ranges from 300-850.”
Reasons for Bad Credit
In some cases, a bad credit score may be due to financial irresponsibility, improper planning, bankruptcy, foreclosure, etc. However, that might not always be the case.
Bad credit may also be caused by the following reasons:
- Not disputing errors on your credit report
Check through your report to spot any mistakes that you need to address.
- Overuse of your credit cards
Overspending brings more harm than good. If you rack up too many bills too quickly, your credit score can drop.
- Defaulting on payments
Defaulting on a loan is a negative sign to prospective lenders, and indicates that you are a credit risk.
- Ignoring notices from lenders
Lenders may reach out to you through phone calls. Always stay in touch and try to negotiate with them so you can keep up with your payment schedule.
- Late payment
Delaying your payments will definitely make you seem less accountable.
- Ignoring bills
Ignoring bills is risky as it can lead to your debt going into collection.
Problems You May Encounter Due to Bad Credit
Having bad credit can have serious repercussions, such as:
- Difficulty getting approved for a loan
- Higher interest rates on loans and credit cards
- Restrictive terms for loans and credit cards
- Higher down payment for loans
- Calls and follow-up from debt collectors
- Trouble finding a job (in certain states, employers can make hiring decisions based on your credit score)
- Difficulty finding a house (within specific guidelines, landlords can evaluate you as a potential renter by checking your credit history)
- Higher insurance premiums
How to Avoid Bad Credit
The good news is you can avoid bad credit and eliminate the related consequences.
To achieve that, take these critical steps:
- Pay your bills on time
Set up payment reminders through a planner or online so you don’t forget the payment deadlines.
- Know which bills report to credit bureaus
This does not mean to avoid paying lenders who don’t list you immediately. Have a solid plan on how to get the rest of the bills paid on time as they can eventually take a toll on your credit.
- Avoid debts
Avoid taking unnecessary debts to finance your lifestyle. When you pile up too much unnecessary debt, you may end up failing to pay the important bills.
- Get good at managing your money
Before you think of getting a loan, learn how to use the money you already have as effectively as possible. Learn the difference between essential needs and frivolous wants.
- Save for unexpected emergencies
Always have some money put aside to deal with any unexpected event. This is a crucial factor seeing that a growing number of Americans don’t have emergency savings.
How to Rebuild Bad Credit
It’s a good sign that the average credit score of Americans has been rising over the years. It shows the potential of rebuilding your bad credit and achieving financial freedom.
Below are 9 ways you can rebuild bad credit:
- Assess the situation
Visit or call different bureaus to get your credit report. Evaluate and compare them for any discrepancies, errors, and inaccuracies.
- Apply for a secured credit card
With a secured credit card, you will pay a specific amount of money upfront as collateral to the credit card issuer. The card limits your credit balance to prevent overspending.
- Avoid missed payments
Try not to miss payments on any existing or new debt. Utilize the lender’s reminders and set up automatic payments.
- Avoid borrowing from high-interest lenders
You might have a problem repaying high-interest loans. Instead, look out for low-interest options.
- Begin saving
Save as much as you can. This may help in paying off some of your debts.
- Pay back on time
Letting your payments go beyond set deadlines can make them more costly due to interest and penalties. Delayed payments will also negatively affect your credit score.
- Negotiate with lenders
Contact your lenders to see if they can adjust the payment schedule to something that works for your budget.
- Develop good financial habits
Create a budget that correctly matches what you earn, and try to live within your means.
Every financial decision you make can push you toward good or bad credit.
Although you can rebuild bad credit, it’s far better and less stressful to avoid bad credit in the first place. Once you have bad credit, it might take you months or even years to get back to good credit.
But don’t despair. Take every necessary step to overcome bad credit, just like some of the most famous personalities who overcame millions of dollars of debt.