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Main Findings
Bad credit is a result of having a history of not paying bills on time, owing too much money, or having negative events on your credit report. Bad credit is reflected in a low credit score, which ranges from 300 to 850. Having bad credit can make it difficult to borrow money, especially at competitive interest rates.
Bad credit refers to a person's history of not paying bills on time and the likelihood that they will fail to make timely payments in the future.
For individuals, it is often reflected in a low credit score, which is a numerical summary of the information in their credit report. Businesses can also have bad credit, affecting their ability to borrow money or access credit facilities.
A low credit score indicates that a person or a business is a risky borrower, who may default on their loans or obligations. Having bad credit can make it difficult to get approved for a loan, a credit card, a mortgage, or even a job. It can also result in higher interest rates, fees, and penalties.
Why Does Bad Credit Happen?
Bad credit can happen for various reasons, such as:
Late or missed payments
This is the most common and influential factor that affects credit scores. Paying bills on time shows that a person or a business is responsible and reliable. Missing payments or paying late shows the opposite and can damage their credit reputation.
Using too much of their credit limit
This is also known as having a high credit utilization ratio, which compares how much money a person or a business has available to borrow (such as the total limits on their credit cards) to how much they owe at any given time.
Having a high credit utilization ratio (say, above 30%) can be viewed as a sign of financial stress and result in a lower credit score.
Filing for bankruptcy
This is a legal process that allows a person or a business to discharge some or all of their debts when they cannot repay them. Bankruptcy can provide relief from overwhelming debt, but it also has severe consequences for credit scores.
A bankruptcy can stay on a credit report for up to 10 years and make it very hard to get new credit in the future.
Identity theft or fraud
This is when someone uses another person's or business's personal or financial information without their permission to commit fraud or theft. Identity theft or fraud can result in unauthorized charges, accounts, or loans that can damage the victim's credit score and reputation.
How to Calculate Bad Credit?
There are different ways to calculate bad credit, depending on the method used to measure it. The most common method is to use a credit score, which is a number that ranges from 300 to 850 and represents the creditworthiness of a person or a business.
The most widely used credit score in the United States is the FICO Score, which is based on five factors: payment history (35%), amounts owed (30%), length of credit history (15%), mix of credit types (10%), and new credit (10%). Each factor is weighted differently and affects the credit score positively or negatively.
According to FICO, a bad credit score is usually below 580 on a scale of 300 to 850. A person or a business with a bad credit score is considered to have poor or very poor credit quality and is likely to face difficulties getting approved for loans or other forms of credit.
Another method to calculate bad credit is to use the bad debt expense formula, which is an accounting concept that measures how much money a business expects to lose from its customers who cannot pay their bills. Bad debt expense is an expense recorded in the income statement when accounts receivable are not recoverable due to the inability of customers to meet their financial obligations.
There are two methods to calculate bad debt expense: the direct write-off method and the allowance method.
The direct write-off method is the simplest way to calculate bad debt expense.
It involves writing off any bad debts as a loss when they become uncollectible. For example, if a customer owes $1,000 and declares bankruptcy, the business will record a bad debt expense of $1,000 in its income statement and reduce its accounts receivable by $1,000.
The allowance method is the more accurate way to calculate bad debt expense.
It involves estimating how much of the accounts receivable will become uncollectible in the future and setting aside that amount as an allowance for doubtful accounts. For example, if a business expects that 5% of its sales will not be paid by its customers, it will record a bad debt expense of 5% of its sales in its income statement and increase its allowance for doubtful accounts by the same amount.
How to Calculate Bad Credit with Examples?
Here are some examples of how to calculate bad credit using both methods:
Example 1: Using the direct write-off method
A business sells goods worth $10,000 on credit to its customers in January. In February, it learned that one of its customers had gone out of business and could not pay its $500 invoice. The business uses the direct write-off method to calculate its bad debt expense.
Bad debt expense = $500
The business will record the following journal entries in its books:
Debit Bad debt expense: $500
Credit Accounts receivable: $500
This entry will reduce the business's net income by $500 and its accounts receivable by $500.
Example 2: Using the allowance method based on the percentage of sales
A business sells goods worth $10,000 on credit to its customers in January. It estimates that 5% of its sales will become uncollectible in the future. The business uses the allowance method based on the percentage of sales to calculate its bad debt expense.
Bad debt expense = Sales * Estimated percentage of bad debts
Bad debt expense = $10,000 * 5%
Bad debt expense = $500
The business will record the following journal entries in its books:
Debit Bad debt expense: $500
Credit Allowance for doubtful accounts: $500
This entry will reduce the business's net income by $500 and increase its allowance for doubtful accounts by $500. The allowance for doubtful accounts is a contra-asset account that reduces the accounts receivable balance on the balance sheet.
Example 3: Using the allowance method based on percentage of outstanding receivables
A business sells goods worth $10,000 on credit to its customers in January. It has an outstanding balance of $8,000 in its accounts receivable at the end of the month.
It estimates that 10% of its outstanding receivables will become uncollectible in the future. The business uses the allowance method based on the percentage of outstanding receivables to calculate its bad debt expense.
Bad debt expense = Outstanding receivables * Estimated percentage of bad debts
Bad debt expense = $8,000 * 10%
Bad debt expense = $800
The business will record the following journal entries in its books:
Debit Bad debt expense: $800
Credit Allowance for doubtful accounts: $800
This entry will reduce the business's net income by $800 and increase its allowance for doubtful accounts by $800. The allowance for doubtful accounts is a contra-asset account that reduces the accounts receivable balance on the balance sheet.
Examples
Here are some examples of how bad credit can affect different types of borrowers:
Alice has a credit score of 550 and wants to buy a car. She applies for an auto loan from a bank, but she is rejected because of her low score. She then tries to get a loan from a subprime lender, but the interest rate is 18% and the monthly payment is $450 for a $10,000 loan. She decides to wait until she can improve her credit score before buying a car.
Bob has a credit score of 580 and wants to rent an apartment. He finds a nice one-bedroom unit for $800 a month, but the landlord requires a credit check. Bob's score is below the minimum requirement of 600, so he is asked to pay a security deposit of $1,600 and a co-signer. Bob doesn't have enough savings or a co-signer, so he has to look for another place.
Carol has a credit score of 560 and wants to start a small business. She needs some capital to buy equipment and inventory, so she applies for a business loan from a local bank. However, her score is too low to qualify for the loan, and she doesn't have any collateral or personal guarantee. She then tries to get a loan from an online lender, but the interest rate is 25% and the repayment term is 12 months. She decides to postpone her business plan until she can raise some funds from other sources.
Limitations
Bad credit can limit your financial opportunities and make it harder to achieve your goals. Some of the limitations of bad credit are:
Higher interest rates and fees
Lenders charge higher interest rates and fees to borrowers with bad credit because they are considered riskier. This means you will pay more money over the life of the loan and have less cash flow for other expenses.
Lower credit limits and loan amounts
Lenders may offer lower credit limits and loan amounts to borrowers with bad credit because they want to reduce their exposure to potential losses. This means you will have less access to credit and may not be able to afford what you need or want.
Fewer options and choices
Lenders may reject your application or offer unfavorable terms if you have bad credit. This means you will have fewer options and choices when it comes to borrowing money or using credit cards. You may also have difficulty finding housing, insurance, utilities, or employment that requires good credit.
Negative impact on your credit score
Having bad credit can further damage your credit score if you continue to make late payments, default on your loans, or incur more debt. This means you will have a harder time improving your credit situation and getting out of debt.
Conclusion
Bad credit is a result of having a history of not paying bills on time, owing too much money, or having negative events on your credit report. Bad credit is reflected in a low credit score, which ranges from 300 to 850.
Having bad credit can make it difficult to borrow money, especially at competitive interest rates. It can also affect your ability to rent an apartment, start a business, or get a job. To avoid bad credit, you should pay your bills on time, keep your debt balances low, use different types of credit wisely, and check your credit report regularly for errors.
References
- Bad Credit: Definition, Examples, and How to Improve - Investopedia: https://www.investopedia.com/terms/b/bad-credit.asp
- Bad Debt Expense Formula | How to Calculate? (Examples) - WallStreetMojo: https://www.wallstreetmojo.com/bad-debt-expense-formula/
- What Is Bad Credit? - The Balance: https://www.thebalancemoney.com/what-is-bad-credit-960369
- What Is Bad Credit? - NerdWallet: https://www.nerdwallet.com/article/finance/what-is-bad-credit-score
FAQ
Bad credit can lead to higher insurance premiums. Insurance companies often use credit-based insurance scores to determine premiums, and a lower score can result in higher premiums.
Some employers check credit reports during the hiring process. If you have bad credit, it could potentially impact an employer’s decision, especially for positions that involve handling money or sensitive financial information.
Yes, bad credit can be repaired over time. This usually involves paying off outstanding debts, making payments on time, and keeping credit balances low. It’s also important to regularly check your credit report for errors and dispute them if necessary.
A secured credit card is a type of credit card where you make a deposit into a savings account that “secures” the line of credit the bank or lender is extending to you.
Your credit limit is typically equal to your deposit. Making regular, on-time payments on a secured card can help improve your credit score over time.
Bankruptcy can severely impact your credit score and it can stay on your credit report for up to 10 years.
However, the impact of bankruptcy on your credit score can lessen over time, especially if positive financial habits are adopted.
A credit builder loan is a type of loan offered by some financial institutions to help individuals build their credit.
The money borrowed is held by the lender in an account not accessible by the borrower until the loan is paid off. Payments made by the borrower are reported to credit bureaus, helping to improve the borrower’s credit score.
