What is Bad Debt or Bad Loan?
Bad debt is money that someone owes you but will probably never pay back. It is a loan or credit that the person who borrowed the money is not paying back like they are supposed to.
Extending Credit and Getting Paid Back
When a bank or business lets someone borrow money or buy something now and pay later, this is called extending credit. The person who borrows the money or buys on credit is supposed to pay back what they owe plus some extra money called interest. Interest is how the bank or business makes money for letting people borrow.
If the person pays back the money they borrowed plus interest, everything is good. This is called being current on their payments. But sometimes the person can’t pay or refuses to pay what they owe. Maybe they borrowed more than they can afford, or maybe they just decide they don’t want to pay.
When Debt Goes Bad
When someone stops paying what they owe and it seems like they probably never will, the bank or business says that debt has “gone bad.” The money that was lent out is now called bad debt because it probably won’t ever be paid back.
Bad debt is a big problem. If a bank lends out money and never gets paid back, the bank loses that money. If a business sells something but never gets the money for it, the business loses money too. Too much bad debt can make a bank or business go broke.
What Happens with Bad Debt?
Banks and businesses have to do something about bad debt. They can’t just pretend it doesn’t exist. There are rules and laws about what to do.
Writing It Off
One thing they do is “write off” the bad debt. This means admitting that the money is probably gone for good. The amount of the bad debt is subtracted from the bank’s or business’s income, so they pay less in taxes. This is because you don’t have to pay taxes on money you didn’t actually get.
Writing off bad debt doesn’t make the debt go away. The person who borrowed the money still owes it. But the bank or business kind of acts like the money is gone, at least for tax and accounting purposes.
Loan Loss Reserves
Another thing banks do is put money into a special account called a loan loss reserve. This is money the bank sets aside to cover loans they think might go bad in the future.
When a loan does go bad, the bank takes money out of the loan loss reserve to replace the lost money from the bad debt. This way, the bank is prepared and doesn’t take a big financial hit every time a loan goes bad.
Selling Bad Debt
Sometimes, banks or businesses will sell their bad debts to a collection agency. A collection agency is a company that tries to get money from people who owe bad debts.
The bank or business sells the debt for less than what is owed on it, so they lose some money. But they get a little money now instead of maybe no money ever. The collection agency buys the debt for a low price and then tries to collect the full amount from the person who owes the money.
Why Bad Debt Happens
There are different reasons why a debt might go bad.
Borrowers in Trouble
The most common reason is the person who borrowed the money has financial problems and can’t pay. Maybe they lost their job, had unexpected expenses, or just borrowed more than they could afford to pay back. When this happens, the bank or business can try to work with the person to get some of the money back, but they might have to write off the debt as bad.
Bankruptcy
If the person who owes the money files for bankruptcy, their debts might be erased by the court. When this happens, the people or businesses that lent them money might not get anything back. The debt becomes bad.
Fraud
Sometimes, people borrow money or buy things on credit never intending to pay the money back. They lie on their credit applications or use false information. This is called fraud.
It can be hard for banks and businesses to spot fraud right away. By the time they realize the debt is bad because of fraud, it might be too late to get the money back.
Bad Debt Affects Everyone
Bad debt isn’t just a problem for banks and businesses. It can affect regular people too, even if they don’t owe any bad debts themselves.
Higher Interest Rates
When banks and businesses lose money to bad debt, they have to make up for it somehow. One way they do this is by charging higher interest rates on loans and credit cards.
This means that even people who always pay what they owe might have to pay more in interest because of other people’s bad debts.
Higher Prices
Businesses also might raise their prices to make up for money lost to bad debt. If a business isn’t getting paid by some customers, they might charge all their customers more to make up for it.
So even if you always pay your own debts, you might end up paying more for things because of other people’s bad debts.
Difficulty Getting Credit
If you try to get a loan or credit card and you have bad debt in your credit history, it can be very hard to get approved. Banks and businesses look at your credit report to see how risky it is to lend you money.
If you have a history of not paying what you owe, they will be less likely to want to lend you money. They’re afraid your debt to them will go bad too.
Dealing with Your Own Bad Debt
If you have debts that have gone bad, it’s important to deal with them. Ignoring the problem will only make it worse.
Talk to Your Creditors
The first step is to talk to the people or businesses you owe money to, called your creditors. Explain your situation and see if you can work out a payment plan. They would rather get some money from you over time than no money at all.
Get Help from a Credit Counselor
There are organizations that can help you manage your debts and make a plan to pay them off. These are called credit counseling agencies. They can talk to your creditors for you and help you budget your money.
Be careful though – some companies that say they’re credit counselors are actually scams. They might charge you a lot of money without really helping. Look for a reputable non-profit agency.
Consider Bankruptcy
If your debts are too large and you really can’t pay, bankruptcy might be an option. This is a legal process where a court can erase some or all of your debts.
Bankruptcy can give you a fresh start, but it also has serious consequences. It will stay on your credit report for years, making it hard to get credit, rent an apartment, or even get certain jobs.
There are different types of bankruptcy for different situations. If you’re considering bankruptcy, talk to a lawyer who specializes in helping people with debt. Some will give you a free consultation to discuss your options.
