What Is Impaired Credit?

Impaired credit occurs when there has been a deterioration in the creditworthiness of an individual or entity. This is usually reflected through a lower credit score, in the case of an individual, or a reduction in the credit rating assigned to an entity or debt issued by a rating agency or lender. As a result, the borrower whose credit has been impaired will generally have lesser accessibility to credit facilities and will have to pay a higher rate of interest on loans. Impaired credit may either be a temporary situation that can be reversed, or an early sign that the borrower could face potential major financial distress down the road. In either case, impaired credit is not a good omen.

Key Takeaways

  • Impaired credit occurs when there has been a deterioration in the creditworthiness of an individual or entity.
  • Borrowers with impaired credit will generally have lesser accessibility to credit facilities and will have to pay a higher rate of interest on loans.
  • Impaired credit may require drastic changes to operations or procedures to alleviate financial stress--whether that involves paying off debts like credit card debt, or a company reducing expenses and selling assets.

How Impaired Credit Works

Impaired credit is usually the result of financial stress brought on by a change in circumstances for an individual or entity. In the case of an individual, impaired credit may be the end result of a job loss, long illness, a steep decline in asset prices, a failure to pay their credit card bills on time, and a multitude of other reasons. For a corporate entity, creditworthiness may decline if the company's financial position deteriorates over time due to poor management, increased competition, or a weak economy. In either case, impaired credit could be the result of internal forces, or self-inflicted wounds. Or at other times, external factors are at play which may be out of an individual's or management's control.

Impaired credit, whether at the personal level or the corporate level, may require drastic changes to operations or procedures to alleviate financial stress leading to eventual improvements in a balance sheet's condition. These changes generally include reducing expenses, selling assets, and using cash flow to pay down outstanding debt to bring it to a manageable level.

Economies such as the United States are focused heavily on building one's credit, It directly influences the ability and ease to which future loans and money can be accessed to purchase a house, car, or other assets. As a result, impaired credit issues should be addressed immediately.

How to Assess Creditworthiness

Several techniques are available to assess an individual or entity's credit impairment, or more specifically, credit analysis. Common methods begin the four "Cs" of credit:

  • Capacity: The ability to service debt levels
  • Collateral: Any posted collateral as a buffer against market value losses
  • Covenants: Loose or tight covenants to indentures
  • Character: Management's experience, values, and aggressiveness

Many banks will automatically allow their clients to check their FICO credit scores. The highest credit score possible is 850, while generally an individual with a credit score between 670 and 739 is considered to have good credit.