Impaired Credit: What it is, How it Works, How to Assess it

What Is Impaired Credit?

Impaired credit typically refers to a deterioration in the perceived creditworthiness of an individual, a business, or other entity. Impaired credit is usually reflected for individuals in a lower credit score and for businesses and other entities as a lower credit rating. Would-be borrowers with impaired credit will find it harder to obtain loans and generally have to pay higher interest rates if they do. Impaired credit can be either a temporary and fixable condition or a warning sign that even greater financial distress may lie ahead.

How Impaired Credit Works

Impaired credit is usually the result of financial stress brought on by a change in circumstances, often an unforeseen one.

In the case of an individual, impaired credit may be the result of a job loss, a costly illness, a steep decline in asset values, or a multitude of other crises that can make it difficult for a person to keep up with their bills.

For a company, impaired credit might be due to increased competition, a weak economy, supply chain issues, or bad management decisions, among other causes.

How Creditworthiness Is Assessed for Individuals

For individuals, credit scores are the most common and simplest measure of creditworthiness. Credit scores are based on the information in a person's credit report and expressed as a three-digit number, typically ranging from 300 to 850.

Credit scores consider a number of factors and weight them in terms of importance. In the case of FICO scores, the most widely used credit scoring system, the weighting looks like this:

• Payment history (35%)
• Amounts owed (30%)
• Length of credit history (15%)
• Credit mix (10%)
• New credit (10%)

In general, a score below 580 is considered poor, while one between 580 and 669 is considered fair. Good scores begin at 670, very good ones at 740, and exceptional ones at 800.

Someone who once had a good or very good credit score but now has a poor score could be considered credit impaired.

Because payment history and amounts owed count for nearly two-thirds of a person's credit score, it is likely that something has gone wrong in one of those two categories. Payment history reflects whether they have been making their monthly credit payments on time, so perhaps they have, for whatever reason, started paying late or missing payments altogether.

The amounts owed category is largely based on the person's credit utilization ratio, which is the amount they currently owe as a percentage of all the revolving credit they have available to them. For example, if they have two credit cards with a combined credit limit of $20,000 and they owe $10,000 on those cards, their credit utilization ratio is 50%. Credit scores reward lower utilization ratios and punish higher ones, so it's possible that the person has run up much bigger balances than they carried in past. Again, there may be a logical reason for that, but their credit score will still take a hit.

If the individual can keep up with their bills and pay off a large chunk of their outstanding debt, they should be able to restore their credit score over time and no longer be labeled as credit impaired.

How Creditworthiness Is Assessed for Businesses and Governments

Credit ratings agencies assess the creditworthiness of businesses, governments, and other entities, assigning them letter grades rather than numbers. They also rate the credit quality of the debt, such as bonds, that these entities may issue.

The major credit rating agencies are Fitch Ratings, Moody's Investors Service, and S&P Global. Another large ratings agency, AM Best, focuses on the insurance industry. All of these agencies are private companies and typically paid by the entities they rate.

While their ratings systems differ, all assign letter grades from AAA (best) down to C or D (worst) based on their assessment of that particular entity's creditworthiness. The higher the grade, the more likely it will be to repay its debts, in the ratings agency's opinion.

An entity that has dropped a number of letter grades could be considered to be credit impaired.

Credit ratings take a variety of factors into account, which will vary based on the type of entity that's being rated. As S&P Global explains, "the credit analysis of a corporate issuer typically considers many financial and non-financial factors, including key performance indicators, economic, regulatory, and geopolitical influences, management and corporate governance attributes, and competitive position."

In rating a government entity, on the other hand, "the analysis may concentrate on fiscal and economic performance, monetary stability, and the effectiveness of the government's institutions" S&P Global notes.

The Bottom Line

Having impaired credit is not a good situation for a person, business, government, or any other entity to be in. Fortunately, they may be able to improve their standing by addressing the issues that caused their credit scores or credit ratings to call in the first place.