Bad Credit: Meaning; Examples, How to Improve

What Is Bad Credit?

Bad credit refers to a person's history of failing to pay bills on time and the likelihood that they will fail to make timely payments in the future. It is often reflected in a low credit score. Companies can also have bad credit based on their payment history and current financial situation.

A person (or company) with bad credit will find it difficult to borrow money, especially at competitive interest rates, because they are considered riskier than other borrowers. This is true of all types of loans, including both secured and unsecured varieties, though there are options available for the latter.

Understanding Bad Credit

Most Americans who have ever borrowed money or signed up for a credit card will have a credit file at one or more of the three major credit bureaus, Equifax, Experian, and TransUnion. The information in those files, including how much money they owe and whether they pay their bills on time, is used to compute their credit score, a number that's intended as a guide to their creditworthiness. The most common credit score in the United States is the FICO score, named for the Fair Isaac Corporation, which devised it.

A FICO score is made up of five major elements:

1. 35%—payment history. This is given the greatest weight. It simply indicates whether the person whose FICO score it is paid their bills on time. Missing by just a few days can count, although the more delinquent the payment, the worse it is considered.
2. 30%—total amount an individual owes. This includes mortgages, credit card balances, car loans, any bills in collections, court judgments, and other debts. What's especially important here is the person's credit utilization ratio, which compares how much money they have available to borrow (such as the total limits on their credit cards) to how much they owe at any given time. Having a high credit utilization ratio (say, above 20% or 30%) can be viewed as a danger signal and result in a lower credit score.
3. 15%—length of a person's credit history.
4. 10%—mix of credit types. This can include mortgages, car loans, and credit cards.
5. 10%—new credit. This includes what someone has recently taken on or applied for.

Examples of Bad Credit

FICO scores range from 300 to 850, and traditionally, borrowers with scores of 579 or lower are considered to have bad credit. According to Experian, about 62% of borrowers with scores at or below 579 are likely to become seriously delinquent on their loans in the future.

Scores between 580 and 669 are labeled as fair. These borrowers are substantially less likely to become seriously delinquent on loans, making them much less risky to lend to than those with bad credit scores. However, even borrowers within this range may face higher interest rates or have trouble securing loans, compared with borrowers who are closer to that top 850 mark.

How to Improve Bad Credit

If you have bad credit (or fair credit), there are steps you can take to get your credit score above 669—and keep it there. Here are some tips for accomplishing that, straight from FICO.

Set Up Automatic Online Payments

Do this for all of your credit cards and loans, or at least get on the email or text reminder lists provided by the lenders. This will help ensure that you pay at least the minimum on time every month.

Pay Down Credit Card Debt

Make payments above the minimum due whenever possible. Set a realistic repayment goal and work toward it gradually. Having high total credit card debt damages your credit score and paying more than the minimum due can help raise it.

Check Interest Rate Disclosures

Credit card accounts provide these disclosures. Focus on paying off the highest-interest debt fastest. This will free up the most cash, which you can then begin to apply to other, lower-interest debts.

Keep Unused Credit Card Accounts Open

Don't close your unused credit card accounts. And don't open new accounts that you don't need. Either move can damage your credit score.

If bad credit has made it difficult for you to get a regular credit card, consider applying for a secured credit card. It is similar to a bank debit card, in that it allows you to spend only the amount you have on deposit. Having a secured card and making timely payments on it can help you rebuild a bad credit rating and eventually qualify for a regular card. It also is a good way for young adults to begin to establish a credit history.

The Bottom Line

Bad credit can be a major roadblock if you're trying to purchase a house or car, so knowing what impacts it is important. If you have bad credit, paying your debts on time and paying down high balances can improve your score and make you more attractive to lenders. If you feel like you're drowning, a debt advisor may be able to help.