What is Bad Credit? How It Impacts Credit Card Approval and Interest Rates 

If you worry about having bad credit, you’re not alone. I have counseled many clients who were distressed about their low credit scores, and I have also, on occasion, made mistakes that caused my own credit scores to dip temporarily. 

Bad credit simply means there is information on your consumer credit report that indicates a history of problems repaying borrowed money or too much debt.

Bad credit can result from a series of late payments or an overabundance of debt. Basically, certain financial info gives the impression that you are irresponsible with money, unreliable in paying back debts, or experiencing financial trouble. Since information on your credit reports is tabulated into your credit scores, any negative notations will drive those numbers down. 

Low credit scores act as an immediate red flag to credit issuers. They see a low number and know they’re dealing with a risky customer. If you apply for a new account, you may be denied outright. Or if you’re approved, you’ll be saddled with higher-than-ideal interest rates and not as many perks as you want. 

The good news about bad credit? You have the power to change it. I promise. Here’s everything you need to know about credit ratings. 

A lot of my clients want to know how credit scores work exactly. To explain that, I’ll first have to talk about the role of consumer credit bureaus. 

The three major credit bureaus in the United States are Experian, TransUnion, and Equifax. Creditors, businesses, and the courts send these companies a running history of your credit activity. 

For example, if you opened a credit card in 2015, the credit bureau would have a record of the date, the card’s credit limit, your monthly payment pattern, and how much you currently owe.

The bureaus then create credit reports — or files — that other businesses can access to find out how you have been managing your credit accounts and debts. 

So let’s stop for a moment and think about this! If someone came to you asking for a loan, you would want to know how they have handled other debts, right? Did they make the payments on time and repay the balance in full? Do they currently owe a lot of money? Essentially, you would want to know how much risk you’re taking in lending them the money. 

Which leads me to the beauty of credit scores.     

Credit scoring companies take the information from your credit reports and input it into their proprietary algorithms to predict credit risk based on past behavior. Because the information on your credit reports is updated with your activity, your credit scores will change over time. 

The two most commonly used credit scores for consumers are the FICO Score and the VantageScore. Both use the 300 to 850 scale. Obviously, higher numbers are preferable because they indicate that you pose less risk to the lender. 

FICO Score

The FICO score, which launched in 1989, is the most widely used credit score by banks and credit card issuers.

This score breaks down into poor to exceptional categories: 

• 300 to 579 are considered poor scores
• 580 to 669 are considered fair scores
• 670 to 739 are considered good scores
• 740 to 799 are considered very good scores
• 800 to 850 are considered exceptional scores

How these scores are determined depends on what is listed on your credit report. Some information is weighted much more heavily than others.

The FICO Score model gives the following weight to these categories:

• 35% Payment History. This includes a monthly overview of your credit card and loan payments, as well as whether accounts have been charged off, gone into collections, or you have been included in bankruptcy. 
• 30% Amounts Owed. Using credit products is positive because it adds information to your reports, but it’s not so positive to get into a large amount of debt. The amount owed compared to the amount you can charge can have a negative impact on your scores. Credit utilization is an important factor to consider for each credit card and in total. 
• 15% Length of Credit History. This category takes into account when your credit accounts were established, the age of your oldest and newest accounts, as well as the average age of all your accounts. 
• 10% Credit Mix. Having a variety of accounts, such as credit cards, retail accounts, and loans, can help your scores rise. 
• 10% New Credit. Because opening several credit accounts in a short span of time can be a red flag, especially if you don’t have much else on your report. Too many applications can hurt your scores. 

Your payment history (whether you pay bills on time) and the total amount you owe hold the most weight.

VantageScore

The three major credit bureaus created their own risk-based model — the VantageScore — in 2006. Although it is not as ubiquitous as the FICO score, it is used by many lenders. 

VantageScores focus on what is and isn’t considered prime credit. If you have super prime credit, you are very likely to handle your credit accounts on time and pay the balance in full. If you have subprime credit, it is highly unlikely that you will pay debts back. 

Here are how the scores break down:

• 300 to 600 is considered subprime or not prime credit
• 601 to 660 is considered near prime credit
• 661 to 780 is considered prime credit
• 781 to 850 is considered super prime credit

To calculate your score, VantageScore has determined what information is most influential and what is least influential:

• Extremely influential: payment history
• Highly influential: total credit usage
• Highly influential: credit mix and experience
• Moderately influential: new accounts opened
• Less influential: balances and available credit 

Like the FICO Score, your VantageScore gives significant weight to your payment history.

The VantageScore model places the most emphasis on your payment history and an equal emphasis on your depth of credit and credit utilization.

As a consumer, you will not know nor have any power over which scoring model a credit card company or other lender checks to make a decision. However, because they will use one or the other to determine your qualifications and set interest rates, it is a good idea to check both to see where you stand. 

To get your FICO Score:

• Go to myFICO.com. You can get a score associated with one credit report for free or pay extra for additional scores and services. 
• Check your credit card issuer. Some give cardholders access to a free FICO score.
• Sign up for free Experian credit monitoring. The company will send your FICO score to you once a month.

To get your VantageScore: 

• Go to VantageScore’s partnering providers for free scores, including Capital One CreditWise, Chase Credit Journey, OneMain Financial, and US Bank.

Remember, all credit scores are derived from the information on your credit report. You do not want them to be low due to inaccuracies. Check your reports often so you can monitor activity and ensure that everything is correct. 

Visit AnnualCreditReport.com to access your reports from the three credit bureaus for free (one report per bureau per week).

You will also have the opportunity to dispute anything that you believe is wrong, and the bureau will investigate. If they find it in your favor, the data will be removed, and your scores will rebound. 

In general, having bad credit is not mysterious. I can name some very common reasons for a plummeting credit score. 

Missed Payments

Credit scoring companies rank payment history as the most important factor in their calculations, so if you fall behind and miss a payment cycle, you’ll get dinged.

The more delinquencies you have on your report, especially if they are recent, the more severe the impact on your score. 

Evidence of missed payments will stay on your credit reports for a total of seven years, but their negative impact on a credit score fades as time passes. 

Does this mean you should panic about credit damage if you are a few days past your loan or credit card account’s due date? No, because it would only harm your score if you are later than a complete payment cycle, which can be between 25 and 30 days. 

So don’t worry about being a day or two late, but definitely get your payment in before the cycle ends. 

High Credit Utilization 

One of the most common questions I used to get when I was counseling people was why their credit scores were low after never missing a payment.

“How much credit card debt are you carrying?”  I would ask. Their answers were revealing.  

Maxed-out credit cards and lines of credit are considered highly problematic because it looks like you’re relying on borrowing to get by. 

If one credit card has a credit limit of $5,000 and you are revolving $4,000 worth of debt on it, your credit score will be negatively impacted. 

However, credit scoring companies also calculate the total of your credit lines and how much you owe on all of them. For example, if you can borrow a maximum of $10,000 on three credit cards and your total revolving debt is $8,000, your credit utilization is 80%, which would be considered too high. 

As a general rule, owing no more than 30% of your credit line, per account and in aggregate, is best for your scores. But, honestly, the less you owe, the better. 

Defaults, Bankruptcies, and Legal Judgments

If you continue to not pay your bills as agreed, the creditor will not just notify the credit bureaus that you are progressively late on payments, but eventually the account will go into default and the issuer will charge the debt off. 

At that stage, your credit scores will definitely take a turn for the worse. 

If a collection agency acquires the account, that company will usually report to the bureaus, and that notification will further hurt your credit scores. 

Filing for personal bankruptcy can offer financial relief and a fresh start, but it will be the absolute worst thing you can do for your credit scores.

• Chapter 7, where you walk away from all allowable and included debts, will remain on your credit report for 10 years after you file.
• Chapter 13, which is a type of discharge and repayment plan, will remain on your credit report for seven years. 

Let’s say you neither repay the debt that you owe nor go through the bankruptcy process. Then creditors and collection agencies can sue you for the amount due. 

If they win and receive a judgment, the repercussions can include wage garnishments, but at least the judgment can’t appear on your credit report. Therefore, it won’t directly affect your credit score. 

Now for the scary part. If you do have bad credit, be aware that you could face some unpleasant consequences. 

Higher Interest Rates

The good news is that certain credit cards and loans have been developed specifically for people who have low credit scores. The bad news is that these products will almost certainly come with high interest rates. 

A high interest rate will increase the cost of borrowing — in some cases quite dramatically. 

For example, a $5,000 loan with a 10% interest rate and a term of three years will cost you $808.09 in interest. If the interest rate were 25%, the total interest would be $2,156.77. 

High interest rates can have a serious impact on your present and future. After all, the more you pay in interest on credit products, the less money you have available for the things you want and need. Not to mention your savings. 

Difficulty Getting Approved for Loans 

Lenders have the discretion to set their standards regarding credit acceptance. Some products are specifically developed for people who have credit scores above a certain figure or who have no evidence of late payments or a bankruptcy listed on their credit report. If you apply for one of them, you almost certainly will be denied. 

One of the most difficult situations will be if you are in the market for a home loan. Conventional mortgages typically require credit scores to be at least 620. 

So if your FICO scores are poor or your VantageScores are subprime, you can experience an almost guaranteed rejection. That can put you out of the running for your dream home — until you bring your scores up. 

Limited Credit Card Options

There are certainly credit cards for people who have bad credit, but your options will be far fewer than if your credit scores were good or prime. 

The cards that will be in your scoring range will usually have higher than average interest rates and fewer perks and benefits. Many do have rewards programs, but the earning potential will likely be less. 

In the event that you are eligible for an unsecured card, the credit limit will probably be very low, at least in the beginning. That can be a hardship if you want to charge something expensive. 

Many secured credit cards are developed for people with bad credit, but you will have to set cash aside with the credit card issuer. If you need that money for other expenses, having it locked away can put you in a tough position. If you treat the account well, though, the issuer may release the funds after a certain number of months. 

Don’t despair if you have bad credit today. With the right actions, it is possible to make a significant difference in a year (or even less if you really hustle). Here’s how to rehabilitate your credit: 

Make Payments on Time

You cannot remove accurate but negative information from your credit report before it naturally ages off. But you can start to make on-time payments going forward. As the timely payments build up, the late payments will become less impactful. 

In many cases, you can start to see a positive difference in your scores in as little as three to six months. 

I’m a big fan of setting up systems that will make your life easier. Therefore, instead of struggling to remember due dates, use technology to your advantage. Enroll in automatic bill pay with your bank, credit card issuer, and lenders. 

This way, the money will automatically come out of your checking account and be applied to your credit cards and loans before the due date. If you can’t or would rather not use bill pay, you may be able to have those companies send you a text or email reminder that your bill will soon be due. 

Reduce Your Credit Utilization Ratio

If your credit scores are low because the amount you owe on credit cards is too high, you can make an almost immediate improvement by opening up your credit utilization ratio.

Here’s what you can do:

• Use savings to pay accounts down or off.
• Make extra-large payments to your accounts.
• Concentrate on paying maxed-out accounts down before you move on to those with lower credit utilization ratios.
• Transfer credit card debt to a consolidation loan. 

Also, find out if your credit card issuer will grant you a higher credit limit. If you have made your payments on time, they may agree.

Dispute Errors on Your Credit Report

Discovering mistakes or evidence of fraud on your credit report can be scary. Yet disputing those errors and having them removed so they no longer hurt your scores can be much easier than you think.

• Dispute the matter with the credit bureau. The online form is simple to complete. It gives you the opportunity to explain why something is wrong. You can also submit supporting documentation. For example, if you paid a collection account off six months ago, and it’s still showing up as unpaid, you will be able to show proof of payment along with the date. 
• Contact the furnisher. Alert the company supplying the information and let them know that they are reporting inaccurate data to the credit bureaus. Explain that you have already filed a dispute, but they should also stop. 
• Wait 30 to 45 days. By law, the credit bureaus must conduct an investigation based on your report and will respond to your dispute within 30 to 45 days. 
• Check your credit reports for updates. If you are in the right, that information can no longer be listed. The next time the credit scoring companies calculate your scores, it will only be accurate information. Be sure to check your reports in a couple of months, though, to make sure it’s been updated. 

Fixing errors on your credit report can be a pain, but it’s well worth your time.

Add Positive Information to Your Credit Report 

Yet another way to improve a damaged credit score is to add positive information to your credit report.  

Experian’s free Boost program comes in handy because you can add regular bills, including utilities and cell phone accounts, to your Experian credit report. When you pay them on time, it will be noted in the payment history section of your credit report. 

In just a couple of months, you can see an improvement in your FICO scores associated with your credit report from this bureau without having to use your credit cards or take out a new account. 

If you are a renter, you may sign up with a company, such as Piñata, that reports rental payments to the three credit bureaus at no charge to you. All the bureaus will include them in your credit reports when they begin to receive them. VantageScores will include the reported rent payments in their scoring models, and newer versions of the FICO Score do as well. 

Always remember that credit reports and credit scores are just a snapshot in time. If your scores are poor now, they can definitely hurt your chances of getting the best credit products available today, but you can take action to make a major difference in your credit—and it’ll change faster than you may think. 

Once your credit is in good shape, make a point of keeping it there. Pay all the accounts that appear on your credit reports on time and make sure your credit card balances remain well below the credit limit. 

By being informed and proactive, you can achieve your financial goals without bad credit dragging you down.