Understanding Bad Credit
Got Bad Credit?
You’re not alone. 1 in 7 US citizens have bad credit and have had to deal with the consequences. Your credit is based on your credit report, which shows your credit and loan history, giving lenders an idea of how you have handled your debts thus far.
While your credit history says nothing of your self-worth and character, it is one of the few ways creditors can gauge your ability to repay a loan on time. In fact, many responsible people tarnish their credit scores without even realizing it.
Before deciding if you want a bad credit personal loan, find out what your credit is based on. You may be able to improve your credit first, providing you with more loan options.
What’s In a Credit Score?
Credit scores are the three digit numbers that are based on the history in your credit report. The credit report information is supplied by lenders that submit your loan information, such as payment history and use of available credit. A mathematical equation uses this information to formulate your credit score.
There are 5 main items that determine your credit score:
- Payment History
- Amount Owed
- Length of Credit History
- New Credit
- Types of Credit Used
Your payment history makes up 35% of your overall credit score. It is the biggest determining factor of your credit score, which is why it is so important to repay your debt on time. Payment history encompasses all types of payments, including unpaid utility bills that end up in collections. The best way to improve your score is by making repaying your loans on time.
The amount owed constitutes 30% of your credit score and refers to how much debt you owe. The amount owed specifically targets revolving lines of credit, or loans that can be paid down and charged up depending on how much credit is available, such as credit cards. Installment loans, or loans that have fixed payments are not included in this credit calculation.
If you have a credit limit of $500 and owe $450, you have used up most of your credit limit. Using up your credit limit negatively affects your credit score because it suggests that you are relying too heavily on your credit cards and that you are incapable of paying down your debts. Financial experts recommend owing no more than 30% of your credit limit.
Length of Credit History
You are rewarded for being a long-standing credit user! 15% of your credit score is determined by how long you have had each of your accounts and how long it has been since your account has been active. This is why it is best to keep older accounts open - the longer history shows you have experience using credit, helping your credit score! People who have no history of credit use have low scores, but they can start building their credit at any time to improve their scores.
Opening new credit can actually hurt your credit score, because opening a lot of new credit hints at financial struggles and a need for a lot of available credit. Oftentimes, we negatively impact our credit scores by opening credit cards for each store we frequent. Whether you’re new to using credit or not, limit the amount of credit accounts you open to what you absolutely need. New credit accounts for 10% of your credit score.
Types of Credit Used
10% of your credit score is based on the different types of credit used. What will help your credit score? Diversity. Having different types of loans (like revolving lines of credit or installment loans) demonstrates that you have experience using different forms of credit and can manage credit responsibly (assuming your repayment history and amount of debt owed also reflect this notion). Data has even implied that borrowers with various types of loans are more likely to repay debt on time.
Now you know how your credit score is determined, but do you know how bad credit affects you?
Bad Credit Impacts Loan Options
Borrowers with bad credit have difficulty getting loans because their credit history suggests they are not very responsible with credit. Lenders are less inclined to provide credit for bad credit borrowers because there is a better chance the loan will not be repaid.
If lenders do offer borrowers with bad credit loans, the loans will be more costly. Lenders recognize the risks involved when lending to people with bad credit, so they charge higher interest rates to make up for any potential losses.
Bad Credit Loans Still Available
Bad credit borrowers still have access to a number of loans, including payday loans, bad credit personal loans, bad credit car loans and bad credit home loans. While these bad credit loans are comparable to loans for people with good credit, they tend to have higher interest rates and, sometimes, less desirable terms.
Wait and Improve Your Credit
Your credit history may show poor credit habits, but those tend to fall off over time. How much time? Well, it depends on what is being reported. The amount you owe can change right away (if you pay down your debts right away), whereas bankruptcies can take up to 10 years to fall off your credit report.
Don’t fret! As negative credit history falls off your credit report, it will be replaced by new credit activity. Eventually, positive changes to your credit history will start to outweigh the negative information on your credit report and raise your credit score.
Paying down your debts is one way of improving your credit score right away. Making payments on time may not be calculated into your score right away, but over time it will improve your credit, as payment history has a substantial weight when measured into your credit score. Now that you know what affects your credit score, you can start making changes today that will improve your credit tomorrow.