Editorial Policy

Which is worse: Bad credit or no credit?

Erica Sandberg

November 18, 2013

QDear Erica,

If you had two good kids, but one has bad credit and the other one has no credit, which one would you lend money to first? — Megan

ADear Megan,

Between those two choices I'd have to go with the kid who has a secure job and something I can hold on to as collateral.

As you may have heard, a person who doesn't possess any credit history is strikingly similar in the eyes of a creditor to someone who has used but abused credit. Both are risky customers. Here's why:

Before granting a line of credit or a loan, creditors will want to predict how that potential borrower will probably behave. To do so, they analyze that person's credit reports (and the credit scores that are derived from the financial information on them), as they provide data about a person's past credit use.Ask Erica

In the trade line section of the report, creditors will see such information as when accounts were granted, current balances, credit limits and a detailed payment history The creditor can analyze the report and make a proper lending decision, or just rely on the credit score (which takes all that data and turns it into a number). If the report shows responsibility and the score is high, the creditor's risk in lending money to that person goes down.

Yet, without a report and its complementary score, creditors can't make such predictions. A blank credit history, therefore, is no good to them at all. The end result is that the child with “no credit” is too mysterious to be considered a good credit risk.

Regarding the child with damaged credit, naturally that person would also be one that a lender would be hesitant to do business with. Not paying bills on time or letting them go into collections will scare any lender away. Owing too much money also looks bad. It could be an indication that the person mismanages finances or can't afford living expenses. Additionally, a portion of that person's income is already promised to other obligations, making another debt difficult to repay.

Naturally, however, there are other qualifying factors when analyzing someone for a loan. The past is not always an indication of the future. Present and upcoming circumstances matter, too. That's why I said I'd be prone to lending to the child who is earning a steady income and who can provide me with some tangible security. Both of those would boost my confidence level measurably.

A job that the person has kept for a long time is positive because there is some cash flow with which to repay the loan. If there were to be some valuable property I could keep in case of default (such as a bicycle or laptop), that would be even better. I'd feel even safer because, if the person defaulted, I could sell the item and recoup my losses. Card issuers sometimes ask for collateral, too, in the form of a product called a secured credit card – a card made specifically for those with poor or no credit. The cardholder puts down a deposit to secure the credit line. If he or she defaults, the creditor keeps the money.

So there you go. I can't tell you which of your children you should open your wallet to (I presume these are your kids we're talking about!) since I don't know them personally, but if you want to think like a lender, that's how you do it. And quite frankly, it's a sound method. Remove the emotion from the equation and you're left with one cold hard question: Who is more likely to pay as promised?

Got a question for Erica? Send her an email.