How Bad Is Bad Credit?
By John Ulzheimer
So exactly how “bad” is bad credit? It might be more appropriate to call bad credit something else. Perhaps it should be called “anything but good” credit, because that’s really what it boils down to.
Just to clarify, when we talk about “bad” credit, we’re specifically referring to a consumer’s credit reports and credit scores. The problem that consumers face is that they improperly define bad credit as being any credit report with bad stuff on it. And, they make the same mistake going the other direction too. They define a good credit report as any credit report that doesn’t have anything bad on it. Neither is correct, because those definitions are simply too broad to be accurate. It’s much more granular than that, and to really understand the differences between bad credit and really bad credit we have to get into the minutia.
The way lending has evolved, we as consumers are basically nothing more than
numbers. These numbers can be our credit scores,
our application scores, or even our insurance scores. These numbers are all
responsible for the offers we get in the mail, the decisions we get when we
apply for credit, deposit requirements from utility companies, credit limits
our credit cards are assigned, and even the amount of money we’re required
to put down as part of a loan.
At this point, the only credit or insurance that consumers can qualify for is commensurate with their level of credit or insurance risk as defined by the aforementioned scores. If your level of risk is pegged as being bad by any of your various scores, so will the offers and terms that you get in return.
There appears to be some confusion among consumers regarding bad credit reports and scores. All bad credit isn’t equally bad. There are grades of “bad,” just like there are grades of “good,” when you’re referring to credit reports and scores.
Take, for example, the 4.0 grading scale for college. A 4.0 grade point average indicates excellent -- perfect, in fact -- performance over a period of time. A 3.8 also indicates excellent performance, as does a 3.7. It would be hard to argue that any of these GPAs are anything less than excellent. But it would be easy to argue that they are not equally excellent.
It’s that dilemma that we run into when we start referring to “bad”
credit. All bad credit isn’t equally bad. Imagine 100 people all with
low credit scores. Collectively, they all have bad credit. However, lenders
and insurance companies don’t view them all as equally bad.
In fact, the good news for consumers who have bad credit is that there is still hope that they can qualify for credit or insurance despite a less than perfect credit history. This is all due to credit scoring.
Prior to credit scoring, lenders did a much poorer job of “rating” applicants. Anyone with really bad stuff on his or her credit reports was considered to be a high risk and treated as such. We now know that you can’t simply pigeonhole everyone whose credit report contains negative items as being an equally bad credit or insurance risk. The statistics have proven otherwise.
Consumers with serious delinquencies are a higher risk than consumers with lower level delinquencies. Those who have recent delinquencies are higher risks than those who have older delinquencies. And, people who have frequent late payments are higher risks than those who infrequently miss a payment here and there.
The problem from the 10,000-foot view is that all of these people mentioned above have one thing in common. They all have delinquencies on their credit reports. In the past, they all would have been considered equally bad credit risks. And, it was very possible that all of them would have be turned down for credit or offered only rates and terms reserved for the highest risk consumers. This, of course, was unfair treatment but at the time nobody really knew that there was an alternative.
Today, we know that there is certainly a very clean and distinguishable line that can be drawn between the many different levels of bad credit. In other words, we can now grade bad credit in such a way that we can easily distinguish between bad, really bad, and horribly bad credit. And we’re not the only ones who have the ability to do this. Lenders and insurance companies have become experts at this as well.
Lenders have developed products and services specific to higher risk consumers. What consumers are going to end up with if they fall into any of the varying definitions of “bad credit” are offers that have lower credit limits, security deposit requirements, higher interest rates, higher premiums, less attractive terms, higher down payment requirements, or flat out denials.
In the past, even the best of the poor credit risks were penalized as much as the worst of the poor credit risks. Today, credit scoring has given lenders the ability to lend “deeper” into the credit pool. In fact, this has lead to new companies that focus their lending efforts solely on the sub-prime borrower.
All this being said, there are still consumers who simply are what lenders consider to be “untouchable” because of the risk involved with lending them money. There are some consumers who simply won’t be able to get any credit at anything other than loan shark rates because their credit is in such bad shape. A good example of this is someone who has just filed for bankruptcy. No lender in their right mind is going to give this person a credit card, or any other type of credit for that matter, because the consumer is in the process of discharging his or her debts as part of bankruptcy protection.
Some lenders even have policies that they will not do business with anyone who has had negative accounts with them in the past unless the consumer settles up, regardless of his or her current credit standing. Some very large credit card issuers employ this policy. So, if I skipped out on my balance at XYZ Bank 10 years ago but have rebuilt my credit since, it’s very possible that XYZ Bank will still not approve me for a credit card because of what I did to them 10 years before. It’s the “fool me once: shame on you; fool me twice: shame on me” approach.
I believe that the confusion for some low-scoring consumers comes from the marketing of offers by those lenders who do business in the high-risk arena. The lenders, who overtly advertise their desire to do business with these consumers, can come across as being able to lend to anyone, regardless of how bad their credit is. Consumers are making the assumption that regardless of how bad their credit is, they can always get a loan from a lender who has “bad credit” programs. That’s simply not the case. You can reach a point where you become uncreditable.
Take, for example, Molly Finnegan from White Sulpher Springs, West Virginia. Molly is 29 years old and works at a local resort as a concierge. She makes a very respectable salary, but her credit is beyond bad. In fact, you’d be hard pressed to find a credit report as poor as Molly’s. She accumulated $107,000 in credit card debt and was forced into bankruptcy when she was 26.
When Molly filed Chapter 7 bankruptcy, it was years ago when you were still able to discharge a majority, if not all, of your debts. So she did. And, while most people learn from their credit mistakes, Molly didn’t. She continued down the same path that lead her to bankruptcy the first time. She has reestablished credit where she could, but has late payments, collections, and public records on her credit reports again. Bankruptcy is not an option for Molly since it has only been 3 years since she filed the first time. Plus, her salary level disqualifies her under the new bankruptcy laws.
Her scores are about as low as they can be. In fact, they are in the lowest 1% nationally. She’s truly in rare company, and in this case that’s not good. It’s not good because lenders have largely chosen to ignore that type of consumer. They simply cannot legally charge enough interest to make it worth doing business with Molly and others like her. Out of every 100 “Mollys,” maybe a dozen will pay their bills on time. You simply don’t want to do business with Molly if you’re a lender.
What’s confusing to Molly, however, is that lenders who have “bad credit” loan programs constantly market to her. She gets offers in the mail, sees ads for them online, and watches their commercials on late night television. But whenever she applies, she gets denied. And, to add insult to injury, each time she applies, the lender pulls her credit reports and posts a credit inquiry, which keeps hurting her scores even more. It would almost be comical, if it weren’t so frustrating for her.
Molly now understands that not all “bad credit” is equal in the eyes of lenders. But it took years of frustration to come to this realization. Some people simply do not make it a priority to pay back their creditors. It’s not because they are bad people; it’s because they simply don’t understand or care about the consequences of their behavior.
How do you know where you stand credit-wise?
One of the many challenges of having bad credit is figuring out exactly how bad you’ve got it. It’s important to know exactly how bad you are so you can save yourself the time and frustration of applying for the offers that are tailored to the highest risk consumers. And, while it might sound difficult, it’s really not that hard if you’re willing to do a little work.
There are many online services that will sell you credit scores and credit rankings. However, if you’re short on cash or you don’t have a credit card, there’s another way to go about it. Everyone in the country is entitled by Federal law to get a free copy of all three of his or her credit reports once a year. You can claim these free reports online at www.annualcreditreport.com or you can make your request by phone by calling 1-877-322-8228. Or, if you don’t have the time to deal with it, you can simply fill out the required forms and mail them.
Once you have your three reports, you will need to take an inventory of the information. What you are trying to determine from your reports are two things:
1. Is there a presence of derogatory information; and
2. How much debt are you carrying?
If you have anything on your credit reports that is considered a major delinquency, it’s hurting your credit rating. If you have a lot of this information, it’s likely causing your situation to be bad to the point that lenders will avoid you for the time being. Here are some general rules that you can follow to interpret the derogatory information on your credit reports;
- Any information appearing in the public records section of your credit report is considered a major delinquency.
- Any information that is, or logically can be assumed is, equal to or worse than a 90 day late payment is considered a major delinquency. This would include foreclosures, collections, severe late payments, repossessions, and settlements.
- Any of the above information that is less than 12 months old is particularly nasty and is having a catastrophic negative impact on your credit rating.
- If you have multiple items that fit the “major delinquency” description, you’re being penalized for the abundance as well.
Now that you’ve gotten a pretty good idea of how bad your bad credit really is, it’s important to determine if your debt is compounding your problems. This is a surprise to some people because the prevailing myth in the credit world, as stated earlier, is still “a good credit report is a credit report without any bad things on it.” And, while that’s partially true, it’s certainly partially untrue.
Your level of debt is as important as your demonstrated willingness to pay your bills on time. If your debt is excessive, it can further lower already low scores or slow your recovery. Here are some general rules that you can follow to interpret the amount of debt that you are currently carrying;
- Add up the total number of accounts that have a balance. The more you have, the lower your scores could be.
- Add up the total number of credit card accounts with a balance. Again, the more you have, the lower your scores could be.
- Determine the utilization percentage of the credit card accounts that are currently open and on your credit reports. You can do this by dividing the credit card balances by their associated credit limits. The higher this percentage, the lower your scores will be.
The worse situation possible would be if you perform poorly areas according to all three criteria. If you fair poorly in all three areas, you are most likely considered to be so bad off that you can’t even get loans from sub-prime lenders.
How do you improve your situation?
The following advice is largely applicable if your scores are poor. If you follow this advice, your scores really have no choice but to improve. The good news for you and others like you with low scores is that they will change in lockstep with the changes on your credit reports. If you can change how you manage credit; you can positively impact your scores. Here are the steps to follow:
- If your credit is truly the worst of the worst, you must start with an epiphany. You have to understand and accept that how you’ve managed your credit up to this point is exactly the opposite of how any reputable lender or insurance company wants and expects you to do so. You can’t fake your way through this. It will require a significant change in your lifestyle and habits. If you’re willing to take on these changes then read on…
- The only way to improve your credit standing is to address the things that you are doing wrong. There is no blanket advice that anyone can give you that will work 100% of the time. Your recovery actions will be different than those of another person in your exact situation. Unfortunately for you, this requires a significant amount of one-on-one time with someone who has mastered the art of credit and credit score management.
- Your recovery plan will involve an initial purging of your current credit accounts. It’s highly likely that you are using creditors who are more concerned about whether or not your next payment will ever arrive and less worried about helping you recover. The goal at the end of the day is to be able to pick and choose whatever reputable lenders you like and have them fall over themselves trying to get your business.
- Unlike advice given by other so-called “experts”, your recovery journey should include only a very short hiatus from the credit world. In fact, if you are planning on exiting the credit environment for more than 12-18 months, you might as well not waste your time. You can’t improve your credit standing unless you jump back into the credit environment as soon as possible. Half your battle will be to convince not only lenders and insurance companies but also the credit scoring models that you are a new person. You can’t do this by living a credit-free life.
- Re-establish credit using any means necessary. You’re not going to get the best rates for years to come, but that’s okay…it’s also your fault. You’re already very used to paying very high interest rates, so this shouldn’t be too hard for you to swallow. But, the pain will be temporary, I promise. You have to build up your credit report with properly managed credit card and loan accounts, and this is going to be costly.
- Once you’ve re-established, it’s time to convert. This will be a most pleasing time in your life. It’s when you’ll be able to look your current lenders in the eyes and tell them to take a hike because they’ve just been replaced with better lenders. Better, in this case, means unsecured credit cards with low rates and high limits and maybe even benefits like airline miles or cash back. It also means competitive terms on car loans, mortgages, insurance, and anything else that requires a company to look at your credit reports and scores.
- Max out. Maxing out doesn’t mean to run your credit card balances to their limits. In this case, it’s the process whereby you will juice every possible credit score point out of every one of your accounts. This, too, requires one-on-one time with an expert, and there aren’t many of us.
This recovery process should take no longer than 5 years. In fact, if you do it right, you should start enjoying credit products reserved for the elite even while you still have those nasty delinquencies on your credit reports. They don’t have to be gone…but they do have to be a clear reflection of your past credit management skills that have now improved to get you back on track. Good luck!!