This is a guest article by Jeremy M. Simon. Each Tuesday, his Credit Score Report column addresses a CreditCards.com reader’s question on credit scoring. He selects questions that either best reflect a common reader concern or that highlight some particularly interesting aspect of credit scoring.
Today, Consumerism Commentary is hosting the weekly question-and-answer session with a query from Amber about her credit history.
Dear Credit Score Report,
If I am offered a settlement by a credit card company or an affiliate (debt collector), how will this affect my credit history? I am not in a good position due to the fact that I am more than 90 days behind. However, I want to repair my credit, not make it worse. Any information would be appreciated that may help in my decision. –- Amber
If you enter a debt settlement program — and repay a loan for less than you borrowed — expect your credit score to take a substantial fall.
Debt settlement typically allows struggling consumers to repay their outstanding loans for less than the amount of the original debt. However, that process will cause your FICO score to plunge by up to 125 points, and you may get hit with a big tax bill. The good news, experts say, is that better options might be out there, and a good credit counselor can help you sort them out.
“Settling the debt may or may not be the right action depending on her overall financial situation,” says Rod Griffin, director of public education at credit bureau Experian. “There may be better alternatives.”
That ‘s because debt settlement will impact both your credit score and your wallet. Here’s how it works: Once the card issuer (or affiliated debt collector) accepts your smaller repayment, it will appear on your credit report and impact your ability to borrow for years. “Such a notation will be viewed negatively by lenders,” says Rod Griffin, director of public education at credit bureau Experian. “The record will remain on her report for seven years from the original delinquency date of the debt.” During that time, your lower credit score could mean difficulty borrowing money, higher insurance costs, getting denied for apartment rentals and missing out on job opportunities. Additionally, since the Internal Revenue Service views forgiven debt as income, a settlement could cost you at tax time. That makes debt settlement an expensive option. Still, that isn’t reason enough to rule it out. “Settling debts for less than originally agreed will likely hurt her credit scores at first, but doing so could reduce her debt load and allow her to begin reducing other debts she may have,” Griffin says. “The result, over time, is that her credit scores would begin to improve.” If you do decide to go through with a settlement, experts say you shouldn’t agree to anything over the phone. Get the contract in writing and read it carefully before signing.
If debt settlement isn’t for you, experts say borrowers in your difficult position have four main options:
- Remain delinquent.
- Come up with extra money to make payments.
- Work with a credit counselor.
- Declare bankruptcy.
Let’s take a look at these options, one by one.
Remain delinquent. At this point, Amber, your credit score has probably taken a major hit due to your delinquency. “If she’s already 90 days behind, she’s already got serious damage,” says Sandy Shore, a senior counselor with New Jersey-based consumer credit counseling agency Novadebt. That’s confirmed by data released last year by FICO, creator of the most widely used credit scoring model that bears its name. FICO acknowledged that a single 30-day late payment can cause your score to drop by up to 110 points. You’re currently three times as late with your card payment — and are only getting later as time passes.
Come up with extra money to make payments. So where can you find the money to repay that debt? Start by making a budget: Take a serious look at your finances, comparing the money you earn each month with the amount you spend. You may be able to earn more money (maybe you can find extra work?), decrease expenses (do you need cable TV?) or sell items (do you really need a TV at all?). Use any extra money to pay down your debt and prevent further damage to your credit score.
Work with a credit counselor. Of course, for many of us, budgeting isn’t an easy process. If you need outside assistance to get a handle on your finances, seek out a credit counselor. You’ll have to pay for their services, but these financial experts can really help. “A good credit counselor will find out what the problem is, how she got into this mess and do a budget,” says Shore.
To locate a reputable counselor in your area, seek out a member of the Association of Independent Consumer Credit Counseling Agencies (AICCCA) or the National Foundation for Credit Counseling (NFCC). Both organizations’ Web sites offer a way to search for local credit counselors via “find” links on their left-hand toolbars. The counselor you select can make arrangements with your creditors, enabling you to make affordable monthly payments toward eliminating your debt, provided your budget allows it. “A good credit counseling agency will not recommend you go on a debt management program unless you can afford it,” Shore says. Entering a debt management program won’t directly impact your credit score, although it can make future borrowing more challenging.
Bankruptcy. You can also weigh the cost of filing for bankruptcy. Declaring bankruptcy means you don’t have to repay the debt, although that filing will cause your credit to drop even more sharply than a debt settlement — by as much as 240 points, according to FICO. To fully consider what’s involved in bankruptcy, have a free or low-cost initial consultation with a bankruptcy attorney (or even several attorneys) to discuss the details of your specific situation. Shore says to remember that just because you visit an attorney doesn’t mean you have to file for bankruptcy. Additionally, if you do decide to file, “there are ways to re-establish credit after bankruptcy,” she says.
In the end, experts say working with a credit counselor is the best choice overall. “They can help analyze your financial situation, offer possible alternatives to regain control of your personal finances and teach you how to avoid making the same mistakes in the future,” Griffin says.
Updated June 20, 2014 and originally published April 2, 2010.