Understanding credit ratings and lending criteria
Credit scores, such as a FICO score or a VantageScore, provide lenders with a way to measure the creditworthiness of a prospective borrower. Generally, a higher score suggests less risk, while a low score indicates a higher likelihood to default. Although there is no official definition of "good" "fair" or "bad" credit scores, “bad credit” has become widely used to refer to low scores—or those that preclude a prospective borrower from being approved for a personal loan.
What Are Bad Credit Loans?
Accordingly, the term "bad credit loans" or "subprime personal loans" has developed as shorthand for financing programs specifically designed for borrowers with low or poor credit scores. While some mainstream banks and credit unions have tightened their lending criteria, even employing minimum credit score caps, a number of online lenders have seen opportunities to help people with bad credit.
Bad credit ratings are not permanent
It’s important to recognize that credit reports and scores are based on past performance, and therefore not perfect barometers of how prospective borrowers will perform in the future. They don’t really say much about how that person came to have those negative credit entries or low credit scores. It may have come through poor debt management habits, but it may also have been due to setbacks beyond the person’s control, such as a medical emergency or protracted job loss.
Plus, low credit scores and bad credit ratings are not permanent. Credit scores are based on data contained in a person’s credit report and federal law puts time limits on how long most consumer credit entries may remain on a credit report. So it is possible to improve a bad credit score over time by replacing “bad” credit history with positive indicators, such as on-time payments and lower outstanding debts.
What determines “bad credit”?
For personal loan lenders, “bad credit” refers to credit reports with numerous or substantial negative entries that may indicate a higher risk of delinquency, non-payment or default. These negative credit report entries may include the following:
Many lenders simplify or augment their credit underwriting by relying on credit scores. The most commonly known credit scoring system is FICO, which has a range of 300 to 850. Consumer loan companies and lenders have differing lending guidelines and credit score requirements. They also have differing interpretations of what constitutes a “bad” or “less-than-perfect” credit score.
Why do different credit bureaus calculate different credit scores?
There are two main reasons different credit bureaus calculate different scores:
There are many other credit bureaus beyond Equifax, Experian and TransUnion — those are just the three largest and most commonly used.
How do you improve a bad credit score?
With three simple steps, you can begin to repair your credit*:
Obtain your free credit report and correct any errors.
The Fair Credit Reporting Act requires that each of the three credit bureaus provide you with a free credit report every 12 months. The safest way to obtain your free credit reports is from www.annualcreditreport.com, which is sanctioned by the Federal Trade Commission. Unfortunately, if you want to see your FICO scores as well, you will need to pay extra for them. Beware of websites offering free credit scores; there is usually a catch!
Errors can result from clerical mistakes, technical glitches, or even from identity theft. Correcting an error can be the fastest way to begin repairing your credit and should be the first thing you do.
Pay your bills on time
One of the biggest reasons people have bad credit is missed payments. Make sure you have a thorough list of your due dates and the minimum payment amounts, and consider automatic payment options to ensure you never miss a due date. If you think you won’t be able to make a payment, contact your lender before the due date to ask about your options.
Pay down existing debt
Credit scores take into account how much outstanding debt you have and how much unused credit is still available to you. A good rule of thumb is to keep your balance on each line of credit below 35% of your limit.
*This information is for general informational purposes only. You should explore options and consult a financial advisor for advice specific to your circumstances.
Why is not having credit history a problem?
The term “no credit history” typically refers to prospective borrowers whose available credit records show no activity or open accounts.
Lenders—and sometimes even employers or landlords—rely on credit reports to determine the applicant’s creditworthiness. Although the presence of negative credit entries on a consumer credit report can result in a decline, having no credit entries on a report can be equally problematic for potential loan borrowers.
Lenders use credit reports to determine two main things:
Borrower creditworthiness: Lenders have traditionally looked into borrowers’ credit reports to examine and gauge their debt management history. The credit report provides an indication of how well a person manages his or her debts. Having no credit history may show that a person has avoided debt—but then it doesn’t indicate how that borrower would handle his or her debt obligations if approved.
Program eligibility or selection: Lenders also use credit reports and scores to determine which loan program (if any) the applicant is qualified to receive. A credit report with no recent records may not provide lenders with the information they need to determine a borrower’s eligibility.
Credit scoring formulas, such as FICO and VantageScore credit scores, rely on credit entries to calculate credit scores for individual consumers. If there are no credit history entries on a credit report, credit-scoring formulas will be unable to properly calculate a person’s credit scores. When credit-scoring systems encounter a credit report with no recent credit entries, it often provides an “N/A” score.
How can a consumer with no credit start building their credit?
The good news is that many individuals with no credit history can sometimes quickly start adding entries to their credit reports. Here are a few ways they can do so:
Ask creditors to report: Some creditors are willing to report to a credit bureau, but it may take a request from the borrower.
No-credit creditors: Some lenders and creditors specialize in providing starter credit cards to college students, recent graduates and individuals with little or no credit.
Secured credit card: Some credit card providers offer credit cards to individuals with low or no credit, but require a security deposit.
Alternative: Some lenders allow for alternative evidence of credit. For example, some mortgage lenders will accept 12 months of cancelled rent checks as proof of alternative credit history.
Consumers need to be careful when considering and accepting any of the above alternative credit accounts. If properly managed, financing programs for people with no credit can help individuals build or rebuild their credit. However, failure to make payments on time can have the reverse effect — damaging a person’s credit history. The important thing to remember is that having no credit does not have to be permanent.
What are subprime lenders?
A subprime lender is a finance company, lending institution or individual that specializes in issuing loans to borrowers with less-than-perfect credit. Due to the higher risk involved with lending to non-prime consumers, subprime lenders often charge higher interest rates and require different loan terms than prime lenders.