No one is thrilled to have debt, but it’s a part of society.
People don’t always have a chunk of change lying around big enough to pay for a house, a car, a university degree, and a million other pricy things.
Likewise, companies sometimes rely on credit to pay for goods or services from other businesses.
Going into debt can elevate your life or business, but it can also pull you down and cause problems for lenders if they’re unable to collect the money they gave out.
That negative type of debt is called bad debt, and it can be a real headache.
There are two different kinds of bad debt, and in this article, we’re going to take a look at each one and discuss the top things you need to know.
Debt might be unavoidable for most people and businesses, but that doesn’t mean you have to go into it with blinders on!
1. What is Debt?
Before we talk about bad debts, let’s first define what debt is.
Debt is money that a borrower owes to a lender.
The money is typically borrowed to pay for a large expense that the borrower wouldn’t otherwise be able to pay for.
When a bank or lender loans someone money, it usually includes interest rates.
The interest rate is the annual amount that a lender charges for the privilege of taking out a loan–it’s how lenders make money.
Credit cards are also a version of debt.
You can think of a credit account as a loan that a bank has preapproved you for.
Additionally, some businesses provide loans to clients (in the form of credit) to buy goods and services, which is a form of debt.
2. What is Bad Debt and How Does it Work?
There are two types of bad debt.
One type deals with businesses and lenders who are unable to collect loans, and it’s what most people are referring to when speaking about bad debt.
The other concerns individuals who borrow money for things that don’t bring value to their lives.
Let’s take a closer look at each one.
Bad Debt: Businesses and Lenders
When a bank or business gives a client money or accepts credit as a payment, they are taking on the risk of not being paid back.
These lenders will decide whether or not to take the risk based on credit checks and an investigation of the client’s financial history.
Despite doing their due diligence, clients are sometimes unable to repay the borrowed money.
Debts that lenders will likely never be able to recollect are referred to as bad debt.
Bad Debt: Assets That Don’t Appreciate
When someone takes out a loan, if the money is not being used to purchase things that appreciate or benefit one’s life, it’s considered a bad debt.
Credit cards are the perfect example of bad debt.
Most people use their credit accounts to buy clothes, pay for subscriptions, or finance other superficial things.
Bad debt is sometimes unavoidable, but you should be mindful that the money you are spending is not appreciating or adding value to your life (this, of course, is subjective).
When you do use a credit card, always be aware of the bank’s reward programs!
3. What is the Difference Between Good Debts and Bad Debts?
Not all debts are bad.
In fact, some are good!
What exactly does that mean?
Well, you now know that loans or credit accounts that are used on things that don’t appreciate are categorized as bad.
On the flip side, loans or credit accounts that are used on things that appreciate or improve the quality of your life are referred to as good debts.
Here are a few examples:
Student Loans
Business Investments
Anything that creates value, builds wealth, or helps you achieve success and health would be good debt.
Keep in mind that determining whether a debt is good or bad is different for each person.
For example, a loan for a car may be considered good debt if the buyer can get a better job because of it.
But for others, a car loan may be considered bad debt if it was purchased just because the buyer wanted a new vehicle.
Get it now?
4. What Are the Causes?
Bad debt (money that borrowers can’t pay back to a lender) is due to a client not paying back a loan, but what would cause that to happen?
Here’s a quick list of the most common causes.
Unhappy Clients
When a business sells a product or service to clients on credit, those clients may refuse to make payments if they are unhappy with what they received.
The seller would then have to find a way to placate the client or take legal action–this can be detrimental for small businesses.
Financial Hardships
If a client doesn’t have the money or assets to pay back a loan, whelp, that’ll result in a bad debt.
Lenders will track down borrowers who still have the means to make payments, but if the money isn’t there, then the money isn’t there (bankruptcies are a common financial hardship leading to bad debt).
Neglect
Sometimes bad debt is simply caused by negligence.
If the borrower shows no signs of paying back a loan, the lender can take legal action, but that doesn’t always lead to the recollection of the borrowed money.
When the lender no longer wants to pursue payment, it gets reported as bad debt.
5. What Are the Two Methods for Writing off?
Being a lender that doesn’t receive payment from a borrower is frustrating.
What’s even more frustrating is knowing you’ll never be able to collect the money and having to record it as bad debt.
But there’s some good news.
Businesses can write off their bad debt and deduct it from their taxes.
There are two primary ways, and we’re going to take a look at each one.
But before we do, it’s important to note that a business’s bad debt can only be written off if it is partially or totally worthless.
Nonbusiness bad debt can only be written off if it is totally worthless.
You can read more about it on the IRS website.
In the meantime, here are the two main methods to write off bad debt.
Direct Write Off Method
The direct write off method waits until the debt is considered to be uncollectible.
An accountant then debits the Bad Debts Expense account for the amount uncollected and then credits the Accounts Receivable for the same amount.
The idea is to create a contra asset account that reduces the amount of the asset (i.e. the Accounts Receivable) by the amount of the doubtful accounts.
The downside of this method is that it overstates net taxable income.
It should only be used for tax reporting.
Allowance Method
The allowance method is the proactive step of putting aside money to cover bad debts in the future.
Accountants can estimate what percentage of a company’s sales will turn into bad debt by looking at its previous history.
When bad debt occurs, it can be balanced out in the Accounts Receivable in your balance sheet.
This method gives a clearer look at a business’s sales profitability.
6. Can Bad Debt Ever Be Recovered?
Even after the bad debt has been deemed uncollectible and written off, it can still be recovered.
This is referred to as Bad Debt Recovery.
When a lender goes after a borrower for not paying back a loan, the process can be lengthy.
The company has to take multiple steps to get the loan paid.
These steps could include legal action or the offering of settlements.
If the probability of receiving payment is low, the accountants will write off the loss on financial statements, even if there’s still a slight chance of receiving payment.
Sometimes after the loss is already written off, lenders are able to collect because collateral is sold (such as a car or house) or a settlement is finally agreed upon.
If a company writes off doubtful debt and then later collects the full or partial amount, it has to be reported to the IRS.
Accountants have to reverse the loss and include it as a part of the company’s gross income.
7. How to Prevent Bad Debt?
No business wants to take on bad debt.
So, what can companies do to ensure their customers pay them back?
We’re going to take a look at six tips to prevent bad debt, which could save a lot of time and money in the future.
Create Credit Terms
Businesses that allow credit sales to customers need to have clear credit terms.
These terms would include things like late payment interest and early settlement discount policies, which should be presented to customers before they open an account.
The clearer and more upfront a business can be, the better.
Perform Credit Checks
Credit checks will help you identify the chances of bad debt.
If new customers have a poor credit history, it may be better to not allow them to pay with credit or to greatly limit the amount of credit you offer them.
Once a customer has proved their reliability, you can increase their credit limit.
Send Invoices on Time
When customers start to experience financial hardships, only so many of their bills can get paid.
You want your invoice to be at the top of the pile, which makes sending them on time very important.
Additionally, making follow-up calls sooner rather than later can avoid bad debt in the future.
Put Problematic Accounts on Hold
As soon as customers stop making payments or aren’t able to make full payments, putting their accounts on hold can reduce the amount of bad debt you experience in the future.
While the account is on hold, determine whether the customer’s credit line needs to be reduced or eliminated.
Implement a Strict Collection Process
Customers will take advantage of a loose collection process; it’s just a part of the game.
If a customer fails to make payments, go after the money immediately.
The customer should be fully aware of the consequences of not paying, but make sure you follow through with any threats you make, such as legal action or putting accounts on hold.
Reduce Credit Limits for Late Payers
Late payers are better than non-payers, but they are still an issue.
When customers repeatedly make late payments, it’s a clear indication that their credit line needs to be reduced.
You could also slap on other penalties, like taking away discounts and charging late fees.
Any way you can encourage payments to be made on time will help prevent bad debt in the future.
8. Is Owing Debt a Crime?
Owing debt is not a crime, but it can lead to legal action.
No financial institution or business that lent you money can put you in jail or force you into community service for not paying back debt.
That’s the good news.
The bad news is that lenders can come after collateral (the things you paid for with loans).
You can also expect your credit score to drop dramatically if you have unpaid debts.
If you have an unsecured loan, meaning loans that aren’t backed by collateral, lenders will often offer you settlements.
These settlements allow you to pay back less than the original loan amount, but your credit score will still be negatively impacted.
9. Does Unpaid Debt Go Away?
Debt technically never goes away–technically.
Lenders can take a number of steps to collect money from you.
They can even take you to court, and a ruling in their favor could lead to your wages being used to pay off debts.
But debts have a statute of limitations, which means lenders only have a certain amount of time to collect before the debt becomes uncollectible.
That doesn’t mean you can just play the waiting game–bad idea!
Lenders will often take legal action before a debt becomes uncollectible.
Your best bet is to work with a credit counselor to help you make a deal with lenders if you’re unable to pay in full.
10. How to Pay off Debt?
Looking at your debt can be overwhelming, but with the right planning, you can pay it off in no time.
Here are a few strategies to help you achieve freedom!
Snowball Strategy
Focus on paying off the smallest debt accounts first (remember to make minimum payments on the other debts, too).
Once the smallest is paid off, move to the next smallest and keep working upward.
Avalanche Strategy
Focus on paying off the accounts with the highest interest rates (remember to make minimum payments on the other debts, too).
Once the debt with the highest interest rate is paid off, move to the next one.
Consolidate
If you have multiple credit card accounts with high interest, you can consolidate them into one loan at a lower interest rate.
Debt consolidation will lower your overall total (due to less interest) and help you pay it off faster.
If you simply don’t know the best strategy, talk to your creditors or a credit counseling agency to set up a debt management plan.
The sooner you take action, the better the financial position you’ll be in.
11. How does bad debt apply to Homeowner’s Associations?
Just like companies, Homeowner’s Associations can have bad debt.
If you look up the latest budget or financial statement for your HOA, you will likely find the relevant expense line.
In this case, bad debt refers to uncollectible dues.
For some HOAs, bad debt could be one of the largest expense items.
Should this be the case, you may want to pause before purchasing land within the association.
Large amounts of uncollectible dues may mean that many property owners have given up on their properties.
It may also mean that the HOA will have difficulty funding the cost of key maintenance items.
When the association’s operating fund can no longer cover its expenses, it will have to dip into its reserves, cut back, increase dues or take on debt.
None of these options are ideal, which is why large amounts of bad debt in an HOA’s operating budget are a big red flag.
Final Thoughts
The word debt is enough to send shivers down your spine.
Since there are two types of bad debt, let’s quickly recap the meanings.
Bad debt refers to an amount of money that businesses or banks lend to clients that will likely not be paid back.
It can also refer to loans or lines of credit that are used to purchase items that don’t appreciate or add value to your life.
Hopefully, you now have an understanding of bad debt and your future is prosperous!
Additional Resources
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Disclaimer: we are not lawyers, accountants or financial advisors and the information in this article is for informational purposes only. This article is based on our own research and experience and we do our best to keep it accurate and up-to-date, but it may contain errors. Please be sure to consult a legal or financial professional before making any investment decisions.
Prior to starting Gokce Capital, Erika received a Bachelor of Architecture from the University of Southern California and a graduate degree in Urban Policy from Columbia University. She worked as both an architectural designer and engineer in New York before joining the New York City Department of Housing Preservation and Development.
Erika currently lives in the New York Metropolitan area with her spouse, daughter and cat. She is originally from Chicago and still considers herself a midwesterner at heart.
Erika also loves to read, write and travel (fun fact, she has visited all 50 states and more than 30 countries!). Her new book, Land Investing Mistakes: 11 True Stories You Need To Know Before Buying Land, is now available on Amazon.