How Bad Debt Affects Your Credit Score

Bad debt can make you a poor prospect for future credit.
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Any bill or loan that is “non-recoverable,” or has no chance of being paid off, is considered a bad debt. A business typically makes numerous attempts to collect a debt before classifying it as such. Consumers who have one or more bad debts will see a negative impact on their credit score, which can hurt their prospects of applying for loans and financial products in the future.

Type of Debt

Every type of debt carries with it a particular amount of weight with credit rating agencies. Credit rating agencies are responsible for tabulating the borrowing profiles of individuals. A credit score is a numerical value related to the types of loans you have been extended and your timeliness in paying of those loans according to the financial institution’s terms. While there is no specific formula for calculating exactly how much a particular bad debt will lower your credit rating, typically, the higher the loan amount, the greater the impact. For example, if you have a bad debt at a dentist’s office in the amount of $100 and a bad debt with a vehicle leasing company for $25,000, the higher-valued debt will have a higher impact on your credit rating.

Circumstances of Debt

Not all bad debts are seen as equal in the eyes of creditors or the eyes of credit reporting agencies. Some bad debts are partial debts in which a consumer makes an agreement with the credit issuing agency to repay a portion of the full amount owed in exchange for forgiveness of the loan’s balance. Sometimes referred to as a “charge-off,” an example of partial bad debt is a credit card with a balance of $25,000. If a consumer is regularly delinquent on payments or ceases making payments altogether, the credit card company may offer the option of paying a lesser amount in one lump sum payment. If, for example, the consumer agrees to a payment of $15,000, the credit company will charge off the remaining balance and the consumer is no longer responsible for additional payments. The remaining $10,000 is considered a bad or unrecoverable debt for the credit card company, and will be reported to the credit reporting agencies as such. Such agreements typically include a notation that the debt was settled for less than the full balance. While this will still have a negative impact on your credit rating, it will not be as significant as if you let the entire balance of a financial obligation be classified as bad debt.

Explanations for Bad Debt

While potential creditors reference your credit score to determine your credit worthiness, you have the right to include explanations for bad debt that appears on your credit report. For example, if you have a joint account with your spouse and your spouse dies, leaving you unable to pay your debt, the account may go into bad debt status. When applying for credit in the future, you can reference the notation on your credit report and explain the circumstances that led to non-payment. While a reasonable explanation will not change your credit score, it may change the way a credit-issuing agency views your credit worthiness.

Bad Debt Prevention

Bad debt may be prevented by paying all debts on time and by communicating directly with lenders when debt repayment is not possible. Companies may be willing to offer a payment plan or extend the length of a loan, making monthly payments smaller and more manageable.

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