Bad debt can happen to good people. Fortunately, with a bit of planning and a commitment to turning things around, it’s relatively easy to get back in the black.
But before we get started on the road to recovery, what is bad debt to begin with?
Any type of debt you have can be roughly divided into “good” and “bad” debt.
Good debt is a loan that you are able to repay responsibly, based on the terms of the loan agreement. A home loan that is paid off by the due date each month is good debt. So is a business loan where you pay the minimum amount by the due date each month.
Bad debt is a loan that you are unable to repay, or that you haven’t repaid in the past. Debt could also be considered bad when you are repaying it all, but you carry a lot of different debts, or you have a high debt to credit ratio.
Note that there is another definition of good and bad debt. Good debt is debt that makes you money, like a student loan or investment property home loan. And bad debt is debt that costs you money and high interest, like a payday loan or credit card.
However, when the talk turns to your credit profile, bad debt really boils down to debts that you can’t repay, or haven’t repaid in the past.
When you apply for any type of credit, the bank or lender you apply with wants to know what your relationship with money is like. To figure this out, they need to assess the type of risk you pose.
Are you a “pay your bills on time, have savings in the bank, earn more than you spend” kind of risk?
Or are you a “lives week-to-week, robs Peter to pay Paul, has an inconsistent income, always falls behind on your bills” type of risk?
To work this out, lenders look at your credit profile, which acts like a bit of a “money CV”.
It lists all the times you were responsible and conscientious, paying bills on time and paying off your debts.
It also lists all the times you were a bit more footloose and fancy-free. Overdue bills, late payments and debts that were repaid well past their final payment due all get listed on your credit profile.
If your money CV is stacked with bad debts, it’s going to impact your ability to get approved for finance.
If there’s a negative credit entry and you believe there’s been an error, you can contact the credit reporting agency (such as Experian or Equifax) and request they remove the entry. You’ll need to provide proof that you repaid the debt.
But if you have other bad debts lingering in your credit file, here are 6 things you can do to improve your credit going forward:
1. Pay bills on time. Bills that are unpaid for longer than 60 days will appear on your credit report as defaults. They then stay there for five years! If you can’t pay bills on time, call your provider before the due date to negotiate a payment plan or extension. This might help you avoid getting more late payment entries on your file.
2. Lower the limits on your credit card. The higher your limit, the greater the temptation to spend. Also, lenders count every dollar of your credit limit as a debt. A credit card limit of $5,000 with a balance of just $100 is considered to be a $5,000 debt to the bank, because you have access to that cash. Lower the limits to the minimum you need.
3. Make frequent payments on existing loans. A record of small, frequent payments throughout the month can help reduce your debt quicker, and shows the lender that you can plan well and be responsible for your finances.
4. Don’t close credit cards that you’re paying off. Build on good credit and show lenders that you’re trustworthy by being consistent and reliable with your payments. As the balance decreases each month, you can reduce the limit as well so you don’t rack up new debts on these cards. But once the debt level reaches a manageable amount (say $1,000), keep the account at that level.
5. Focus on current debts, not new ones. Don’t apply for additional credit if you’ve been knocked back, because every application leaves a hard enquiry on your credit profile. The only exception to this is if you’re applying for one loan to consolidate your debts and reduce your interest and repayments.
6. Keep track of your credit record. Check in on your credit score regularly and if you find any incorrect entries, contact the credit agency to have them removed. You can check your credit score for free using Finder’s app.
If you’re in a situation where your credit rating has taken a hit, there’s a good chance it will impact your ability to get finance approval. Following the above steps will help you to improve your score and set yourself onto a path of financial confidence.
And in the meantime, if you find yourself in the position of needing a personal loan but you still have a below average credit rating, don’t forget there are bad credit loans available. Be sure to research the lender to make sure they suit your situation and you meet their eligibility requirements before you begin an application. Why? Because applying with numerous lenders in a short space of time is yet another behaviour that can negatively impact your credit rating.
Sarah Megginson is senior editor of home loans for Finder. She was previously managing editor of Australian Broker magazine, Your Investment Property magazine and online home loan comparison site, Your Mortgage. Sarah is a regular media commentator on all real estate and home loans and has worked as a finance and property journalist for more than 15 years.