Editorial Policy

How charge-offs, collections sink your credit score

Erica Sandberg

August 2, 2016

Q Hi Erica,

I often get asked about charge-offs and collections when they appear on a credit report. Some people think charge-offs are fine as it is a “charge off” (as if the debt is not owed — ever). Can you provide the impact of charge-offs and collections? Thank you in advance. — Sahara

A Dear Sahara,

A charge-off is never a good thing, nor is collection activity. Both are clear indications that a person did not repay financial obligations.

Here is a timeline of what typically happens when a borrower avoids a credit card debt and what that does to a person’s credit reports, credit scores and overall finances.

1. A credit card holder makes charges to the account. In about 25 days, the credit card company sends a bill, requesting at least a minimum payment to be sent by a specified date.

2. The cardholder does not pay by the due date, so the credit card company charges a late fee. Interest begins to accrue on the balance.

3. After an entire payment cycle lapses, the company notifies the credit reporting agencies that the account is delinquent. A 30-days “late” notation is recorded on the person’s credit file.

4. As each month goes by without a payment, the credit card company sends increasingly damaging information to the credit reporting agencies. Notices of 60-days late, 90-days late and so forth are posted. Since payment history carries the most weight in a credit score, the person’s credit rating slides. Late fees continue to pile up, and the balance swells with compounded interest. A much higher interest rate usually kicks in, too. This penalty rate could be north of 25 percent.

5. After six months of nonpayment (and if the credit card company decides not to sue for damages), the company removes the debt from its books, declaring the debt a loss. This is a “charge-off,” and it is usually noted as such on a person’s credit report, triggering another credit rating ding.

6. A collection agency then might purchase the dud account for a fraction of the balance, though they will attempt to collect on the full amount. The collector usually notifies the credit reporting agencies that the account is in collections. A large debt also impacts a credit rating because the credit utilization ratio is affected. The more a person owes relative to the amount the person can borrow, the worse the credit score.

This is a common scenario, and there is nothing good about it. Thankfully, it usually can be avoided. How? The best way is to charge only what you can afford to pay for in full and on time.

However, problems arise, so if a person can’t pay at least the minimum payment by the due date, immediately get on the phone with the credit card company and ask for help. In some cases, the card issuer might agree to accept smaller payments for a few months, thus keeping the account current or free from excessive fees and punitive interest rates. Or the debtor might be able to work more and spend less — making it possible to make the necessary payments.

Sometimes a debtor can come up with quick cash to make payments by selling unnecessary items, cashing out an investment account, asking a friend or relative for a loan, or even refinancing a home.

Ignoring credit card debt is not a smart move, as the repercussions can be severe.

For one-on-one guidance, I suggest that overwhelmed borrowers make an appointment at a nonprofit, accredited credit counseling agency. Someone behind on his or her credit card bills can meet with a professional who will review the individual’s income, liabilities and budget. The counselor will draw up an action plan that may help the person avoid charge-offs and collection activity in the first place.

SEE RELATED: Once in collections, debt takes years to erase

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