Here’s what you need to know about impaired credit, including the downsides and possible solutions.
Definition and Examples of Impaired Credit
Impaired credit happens when there is a loss of creditworthiness in an individual or company. For consumers, impaired credit usually results in a lower credit score. Companies may see their credit ratings downgraded. Borrowers with impaired credit have less access to financial products and pay higher interest rates on loans. Impaired credit can be a temporary situation, or a sign that a borrower is facing significant financial problems. Many different situations can result in impaired credit. At times, loss of creditworthiness can be a self-inflicted problem; at other times, it can result from factors outside an individual’s control. For example, some borrowers have impaired credit because they didn’t pay their bills on time or defaulted on a loan. In other cases, a job loss or illness could cause financial problems that lead to impaired credit. Companies may experience impaired credit due to a poor economy or because of financial mismanagement.
How Does Impaired Credit Work?
If a borrower misses a payment, that’s an example of negative information that could impair their credit. The negative marks are added to the credit report. As a result, the borrower doesn’t look as responsible with their credit as they did before the missed payment. Impaired credit is problematic because lenders rely heavily on credit scores to make lending decisions. Impaired credit can make it harder to take out a loan, and your interest rates tend to be higher as your credit score goes lower. A good credit score depends on which scoring model you’re looking at. FICO, a popular model used by many lenders, classifies credit scores like this:
800 and above: Excellent740-799: Very good670-739: Good580-669: FairBelow 580: Bad
The higher your credit score, the easier it will be to qualify for a loan and obtain the most favorable interest rates. Impaired credit can also make it harder to rent a home, get a job, and take out insurance.
Types of Credit
There are multiple types of credit that will show up on your credit report. Here are three of the most common types used to calculate your credit score. Understanding the difference between each of these can help you make better lending decisions.
Installment Credit
If you take out installment credit, that means you agree to make fixed monthly payments over a set period of time. Mortgages, auto loans, and student loans are all examples of installment credit. For instance, let’s say you take out a $250,000 mortgage with 30-year terms. Assuming you took out a fixed-rate loan, you’ll pay a set amount every month until the loan is repaid.
Revolving Credit
Revolving credit means your lender has extended you a line of credit you can use repeatedly. Unlike installment credit, your payments can change from month to month, depending on how much you borrowed. For example, let’s say you take a $5,000 line of credit and spend $500. You have $4,500 in credit remaining, but once you repay the money you borrowed, the entire $5,000 credit line is available to you again.
Open Credit
Open credit combines elements of both installment and revolving credit. With open credit, the amount of money you owe each month can change, and there isn’t a limit to your borrowing, but the payment is always due in full. Your water bill is a type of open credit. The bill changes each month depending on your usage, but the entire balance is due when you receive your updated statement.
