What are Bad Credit Causes?
A lender can deny a potential borrower a loan due to a number of bad credit causes. Bad credit is a person’s record of past failures to make timely payments for bills and loan payments, and the likelihood that they will delay or default on payments in the future. When a potential borrower has a bad credit history, it is difficult for them to get approved for loan applications, credit cards, or even get apartments to rent.
When an individual makes late payments or defaults on the payments altogether, the lender or creditor reports the information to the credit bureaus. The information is included in the individual’s credit report, which lenders and other creditors use to make decisions on whether or not to extend credit to potential borrowers. A corporate borrower can also have bad credit, based on their payment history with creditors.
- Bad credit refers to an individual’s history of poor payment of bills and loans, and the likelihood that he/she will not honor financial obligations in the future.
- A borrower with bad credit will find it difficult to get their loan approved because they are considered a credit risk.
- The common causes of bad credit include late payment of bills, bankruptcy filing, Charge-offs, and defaulting on loans.
Bad Credit Explained
Any person who has borrowed money or applied for a credit card will have an active credit file in one or more of the three credit bureaus. All the credit transactions and events that a person has had in the past years, such as loan applications, number of loans approved/rejected, credit card approvals/rejections, credit card loans, foreclosures, etc. are recorded in the credit report. All this information is accessible to lenders and creditors, who use the information to make lending decisions.
Lenders use the credit report to calculate the credit score, which is a number that shows the level of risk associated with lending money to specific borrowers. Lenders check the credit score of an individual in order to decide whether or not to extend credit, amount of loan they are willing to provide, and the interest rate. Landlords use an individual’s credit report and credit score to get an idea of their credit history and financial situation to determine whether or not to rent them an apartment.
Five Main Causes of Bad Credit
Bad credit is caused by several key factors, as listed below:
1. Late payments
A person’s payment history accounts for 35% of their credit score. If you have delayed making payments for more than a month, the creditor might have reported the information to the credit bureaus. Also, the information is recorded in your credit report.
If you have consistently delayed making payments to lenders, credit card companies, or utility providers, it will affect your credit score. If the bad credit is not repaired, it can lead to the credit score being classified as “poor” or “very poor,” which may diminish your chances of getting approved for a loan.
2. Collection accounts
When creditors are unable to secure payments from a borrower, they can use third-parties to enforce the collection process. Most creditors hire or sell the delinquent debt to debt collection agencies before or after charging off their account.
When delinquent accounts are sent to collections, the information is captured in the credit report. Unless such information is repaired, it will be difficult for creditors to provide credit to a borrower with a history of poor collection.
3. Bankruptcy filing
If an individual or company is unable to pay debts, they may be forced to file for bankruptcy to receive legal protection. Filing for bankruptcy is an extreme event, and it is the most damaging event to an entity’s credit score.
If a borrower files for bankruptcy, the information will be recorded in the credit report, and it stays there for seven years. Due to the complexity of bankruptcy cases, most lenders shy away from lending to borrowers with a history of bankruptcies and court cases relating to their financial situation.
If an account has become delinquent for too long, the creditor will charge off the account. A charge-off means that the creditor has given up trying to get the borrower to make payments, and it leaves a black mark on the credit report. When an account is charged off, the account holder will no longer be able to make purchases with the account. When a charge-off occurs, the borrower still owes the charge-off balance to the creditor.
The unpaid charge-off will cause the credit score to drop. Once an account is charged off, the information is reported to the credit bureaus. The charge-off information remains in the credit report for seven years since the time the account became delinquent.
5. Defaulting on loans
Loans defaults are treated in the same way as an account charge-off. If you have missed more than one payment and you have not paid at the end of the month, the account is marked as in default.
The lender will forward the information to the credit bureaus, and it will damage a borrower’s credit reputation. When prospective lenders access the information, they will view the borrower as a credit risk who is highly unlikely to repay back loans.
CFI is the official provider of the global Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst. Through financial modeling courses, training, and exercises, anyone in the world can become a great analyst.
To keep advancing your career, the additional CFI resources below will be useful: