What is Bad Credit?
The definition of “bad credit” is a lot like the definition of “pretty face.”
It’s all in the eyes of the beholder. Or in this case, the eyes of the lender.
Some banks, credit card companies and online lenders box consumers into a category based only on their credit score. They draw a line at “650” or maybe “630” and if your score is below that mark, you have “bad credit” and are unwelcome.
However, the bank, credit card company or online lender across the street says a credit score of 600, or maybe even as low as 580, is just fine for the loan you want, so sign step right up!
A safe definition of bad credit is when you must accept high interest rates and very uncomfortable terms and conditions just to get a loan. Or, worse than that, when lenders take one look at your credit history and completely reject your loan application.
In either case, if you have bad credit, it means you are considered a “high risk” and you will pay a high interest rate for any loan you get.
Risk-based pricing is when lenders adjust interest rates on loans by estimating the risk the borrower may not repay. Someone with bad credit would be considered a high risk and thus receive a high interest rate. A low-risk borrower receives the lowest interest rates.
Every lender has its own formula for calculating risk, but most include credit score, outstanding debts, income, job status and debt-to-income ratio in arriving at the risk factor. Much of that information comes from your credit report.
If lenders gave you unfavorable terms on a loan and used your credit report in making their decision, you should receive a Risk-Based Pricing notice. If you receive one, you may contact the agency that supplied the credit report to verify that all the information in the report was accurate.
How Credit Agencies Define Bad Credit
FICO, Experian, Equifax and TransUnion, the major credit bureaus and agencies in the U.S., deal in numbers so you won’t get a solid definition from them of what bad credit is. They prefer numeric categories that allow consumers to float from one ranking to another in any given payment period.
Experian, Equifax and TransUnion use the Vantage Score method, which goes from 300 to 850. Experian says it keeps scores for 220 million consumers, almost one-third of which (28%) have bad credit.
Here is a chart produced by Experian with categories broken down by credit score and number of consumers in each category.
From Super-Prime to Sub-Prime to Deep-Prime: Vantage Score Breakdown
- Super-Prime Credit Scores: 781-850 … 48.4 million people
- Prime Credit Scores: 661-780 … 79.2 million people
- Near Prime Credit Scores: 601-660 … 28.6 million people
- Sub-Prime Credit Scores: 500-600 … 50.6 million people
- Deep Sub-Prime Credit Scores: Below 500 … 11 million
FICO, the score most often used by lenders in credit decisions, also ranks consumers on a scale of 300-850, but the FICO scoreboard is a little more stringent.
The top end of the FICO scale is a more inclusive, but the bottom ends is far more demanding, which again emphasizes how bendable the definition is for bad credit. Here is FICO’s scale.
From Excellent to Poor to Bad: FICO Score Breakdowns
- Excellent credit: 750-or higher … 20.4%
- Good credit: 700-749
- Fair credit: 650-699
- Poor credit: 600-649
- Bad credit: Anything below 600 … 20.7%
A FICO survey in 2016 found that 20.4% of consumer were in the exceptional credit category (800-850) and about the same number (20.7%) were in the bad credit range (under 600).
The good news is that the number of people with bad credit has been declining every year since its peak of 25.5% in October 2010. In the six years since then, more than 17.5 million consumers have raised their credit scores above 600.
In fact, in 2016 the national average for FICO scores was 699, the highest in history.
Consequences of Bad Credit
Bad credit is an epidemic in America, with more than half of all consumers strapped with such low credit scores that they can’t borrow at market rates.
Low savings rates and stagnant incomes contribute to the problem. Bad credit hits families hard. They live close to the financial brink, just an expensive car repair or medical emergency away from insolvency. And they are often blocked from borrowing to buy homes, pay for cars and continue education that might lead to better-paying jobs.
Repairing your credit can take time and requires thoughtful money management. Ruining a credit score, however, might not take long at all.
Consider what happened to Jimmy, who lost his job as a welder during the Great Recession. Though he collected state unemployment insurance, it wasn’t enough to pay the mortgage or the expense of raising two small children.
Jimmy ran through his emergency savings in four months. When he stopped paying his mortgage, the bank foreclosed. His two credit cards also fell into default. By the time he eventually returned to work a year later, his family was living with a relative and his credit was flat-lined.
Jimmy’s credit repair job took several years. Even though his income bounced back, albeit at a slightly lower level than before the job loss, he started making payments on his credit card through a debt management program.
But the recovery had consequences. At first, he could only get a secured credit card. When his credit improved enough to qualify for a conventional credit card, he was shocked to learn that the interest rate on unpaid balances would be more than 25%. He also learned that he would have to wait several years to qualify for another mortgage loan.
For folks like Jimmy, a major financial setback is a double whammy. First there is the immediate loss of home and purchasing power of credit cards, then there’s the problem of re-establishing credit. Lending guidelines were tightened after the economic meltdown of 2008, making it even harder for those with tarnished credit to borrow money.
If your credit score falls in the lower regions of either the FICO or Vantage scale, the consequences on your financial life will range from annoying to outright depressing. Lenders use that score against you to impose higher interest rates on loans, longer payoff terms and bigger penalties for late payments. Each of those penalties gouge your bank account and damage your credit reputation.
Lenders make money when consumers repay loans. That is exactly what your credit score is meant to reflect: the likelihood that you will repay a loan. The lower your score, the less likely you are to repay that loan and the more likely you are to incur a penalty.
For example, when you have bad credit and want to buy a car, the lender is taking a bigger risk that you won’t repay the debt so you will pay far more for the loan than someone with a good credit score. If you need to borrow $25,000 with a poor credit score, you’ll pay around 12% interest on a 60-month loan. That means $556 a month payments and $33,360 paid out over the life of the loan.
The same loan for someone with good credit, paying 3% interest would run $450 a month and $27,000 over the course of the five-year loan. That is $6,360 wasted because you have bad credit.
If you’re ready to buy a home with bad credit, the consequences are magnified. Many lenders won’t even deal with consumers who have bad credit. If they do, the interest rate on a 30-year, $100,000 home loan in 2017 would be about 5.5%. That would mean monthly payments of $568 and total payout of $204,480, more than double what you borrowed to start.
With good credit, the interest rate would drop to 4.97% ($535 per mo./$192,600 total) and with excellent credit, the rate would be 4.02% ($478 per mo./$172,285 total). That means bad credit cost consumers somewhere between $12,000 and $32,000 on a $100,000 loan.
The penalties for poor credit don’t stop at home and car buying. Insurance companies could refuse to write car, home or life insurance policies because of bad credit. If they do write the insurance, your rates could be as much as $1,000 higher every month.
Renting an apartment with bad credit is also challenging; utility and cell phone companies require larger deposits and employers who use credit history as part of the hiring process, may disregard your application because you have bad credit.
Finally, your bad credit could lead to a barrage of phone calls from debt collection agencies trying to run down payments that are past due.
In other words, bad credit is going to make your financial life difficult at best and costly at the worst.
“The first thing any lender wants to know is whether you’ve paid your credit accounts on time,” Can Arkali, principal scientist for analytics and scores at FICO, said. “That negative information has a considerable impact on your credit.
“The important thing to keep in mind is that the impact of negative payment information will be less damaging over time if you keep your credit obligations in good standing.”
In other words, make on-time payment credits every month and over the course of time, you can get rid of the “bad credit” label.