Does Debt Relief Hurt Your Credit?
- The debt relief process usually hurts your credit score.
- People with poor credit have less damage, while those with good credit suffer more.
- Studies show that debt relief graduates see their credit scores improve.
How does a debt relief program affect your credit? When you feel like your debt is out of control, it’s time to get help. A debt relief strategy such as debt management, debt consolidation, debt settlement, credit counseling, or bankruptcy may be worth exploring. But does debt relief hurt your credit?
Debt relief programs affect your credit in more than one way. Learn how debt relief programs affect your credit and what you can do to improve your credit score.
Getting Rid of Debt: Sooner Is Better
Every month that your creditors report a late or missed payment takes your credit scores down.
“Many people don’t understand that a credit score impacts the cost of credit, which has real-world consequences,” says Eric Steiner, an attorney with Steiner Law Group, LLC, in Baltimore.
“For example,” he says, “someone with a 750 FICO credit score can finance a car with a low 2.25% interest rate. That means they will pay less for the loan, resulting in a lower monthly payment. But a person with a 520 credit score will pay a ridiculously higher interest rate for credit. As a result, throughout their loan, they may pay almost double the vehicle's actual purchase price, resulting in a significantly higher monthly payment.”
When you realize you have a problematic debt situation, it can be easy to feel overwhelmed and ignore the problem. But this is probably the worst thing you can do.
“If your debt is unpaid for a long enough time, it will most likely eventually make its way to a law firm or collection agency whose only job is to collect the debt. If they sue you and win, which happens frequently, your wages may be garnished to the tune of 25% of your paycheck, which can be crippling. Plus, your credit score and creditworthiness will suffer dramatically,” cautions Steiner.
If this is your situation, doing nothing can be worse for your credit score than even a drastic solution like debt relief.
How Bad Is Your Debt Problem?
In addition to experiencing difficulty making monthly debt payments, a good way to verify that you have a serious debt problem is to calculate your debt-to-income ratio (DTI). You do this by adding up your monthly debt payments like rent or mortgage, credit card minimums, auto loans, etc. (but not living expenses like food or utilities). Next, divide that total by your gross (before-tax) monthly income. The resulting percentage indicates your DTI.
“If your DTI ratio exceeds 50%, you are spending at least half of your gross income toward paying off your debts. Ideally, your DTI should be less than 36%,” says Lyle Solomon, an attorney and financial expert with Rocklin, California-based Oak View Law Group.
In general, the definition of “insolvent” is when you have more liabilities than assets, which is another crucial indicator of being trapped in a severe debt situation, per Steiner. Add the value of what you own and subtract what you owe – if the result is less than zero, you’re insolvent.
“A further way to determine if you are in a bad debt dilemma is to create a monthly budget which analyzes net income and monthly living expenses. If your income isn’t sufficient to cover your debt load after living expenses are paid, it’s clear that you have a debt problem that needs to be addressed,” he adds.
How Debt Relief Affects Your Credit
With debt settlement (also called debt relief), you can reduce the principal amount owed by paying a lump sum to one or more creditors.
“Your debt consultant will negotiate with your multiple creditors to lower the principal amount that you owe,” Solomon explains.
When you opt for debt settlement, creditors usually report to credit bureaus that you paid less than the full balance. And credit scoring models incorporate that in your score, causing a significant drop.
However, the major damage that debt settlement does to credit scores comes from the months prior to settling. That’s because few creditors will accept less than the amount owed if their customers are paying every month as agreed. And most people with debt problems do not have a lump sum with which to settle their debts.
So the way most debt settlement programs work is that you stop paying your unsecured creditors (usually credit card companies) and instead pay into a debt relief account. This accomplishes two things – it convinces the creditors that you can’t afford your payment, and it allows you to save a lump sum.
“This will negatively influence your credit report and may decrease your credit score. Consider that your creditors are not reimbursed immediately if you make monthly payments to a debt settlement company,” adds Solomon.
Data from VantageScore shows that settling an account typically drops credit scores by 45 to 130 points depending on how high the score was to begin with.
However, following the resolution of debt settlement, “it’s likely that your credit score will go up because you’ve resolved one or more debts,” says Steiner.
A study by the American Fair Credit Council found that six months after graduation from a debt relief program, consumer credit scores had risen by 60 points and continued to rise over time. Your success is not guaranteed, however. You must manage debt well in the future to see good results after getting rid of debt.
Credit Impact Varies Widely
Okay, we’ve learned the answer to the question: Does debt relief hurt your credit? Overall, a debt relief option like one of the above might lower your credit score by 100 points or more, according to Solomon, so be prepared.
“Your current credit score, categories of debt, and current credit activity will all influence how much your credit rating will decline,” says Solomon. “The extent to which your credit may suffer will also depend on whether your resolved debt was reported as partially paid or paid in whole by the creditor. The latter will not impact your credit score, but it will drop with the former.”
Interestingly, those who pursue debt relief with poor credit suffer less credit damage than those with good credit.
“People with poor credit usually suffer less damage to their credit score when they get into a debt management program or file for bankruptcy because their credit score was already low. Consequently, the drop does not have much of an impact,” remarks Steiner. “Someone with a high credit score will typically be current on minimum payments but may realize they can no longer afford their payments or will be unable to make a dent in their debt beyond interest-only payments. When these folks enter into a debt management program or file bankruptcy, their credit score will drop more significantly.”
Improving Your Credit Scores After Debt Relief
The good news is that, after your debt is resolved, you can work to improve your credit. Indeed, studies show that debt relief graduates often see their credit scores improve. You can help your cause by taking the following recommended steps to up your credit score:
Make on-time payments. “Make sure you repay your bills before they are due each month. If you can’t pay them in full, try to make minimum payments on your bills,” Solomon advises. “If you have a credit score of 670, for instance, you can raise it by 18 points simply by making on-time payments on all your bills for at least one month.”
Stop using multiple credit cards. If you have more than one credit card, use only one of them to make your purchases so that you can be disciplined to make payments on time. “If you use all of them, you won’t be able to make payments punctually and you’ll pay late penalties. You will prove to be an irresponsible debtor, and your credit score will suffer. Also, avoid applying for new credit cards, as this can lower your credit score by 10% or more,” says Solomon.
Aim to use cash for purchases. “This can help you avoid getting into debt with credit cards or lines of credit,” Solomon adds.
Check your three free credit reports. If you notice any errors or discrepancies, work to have these resolved with each of the three credit bureaus (Experian, TransUnion, and Equifax).
Don’t close credit cards after you pay them off. Doing so can your credit utilization ratio and cause your credit score to drop.
With careful debt management, you can restore your credit after debt relief. And without unaffordable balances to worry about, you may be able to continue improving your credit score and your financial health.
Can a creditor sue me?
In a debt resolution program, you voluntarily stop making payments to your creditors so your accounts go past due. As a result, there’s a chance your creditors may take legal action to collect on the debt. Although we are not lawyers or licensed to practice law, we want to make sure that if any of your enrolled accounts go into litigation, the debt can still be negotiated.
That’s why we’ve partnered with a network of attorneys, the Legal Partner Network, that specialize in debt negotiation. If a creditor takes legal action, we may engage a Legal Partner Network attorney who will attempt to negotiate a settlement with your creditor.
The cost of this service is included in the program and is available to all qualifying clients.
Can you settle credit card debt if you are still current?
Although it is possible to try to settle credit card debt if you are still current, it is unlikely that many creditors will be willing to accept less than the full amount owed if your payments are up to date.
Whether you settle your debt on your own or work with a debt settlement company like Freedom Debt Relief, the most effective way to get creditors to negotiate is by showing them you are unable to pay your debt in full due to a financial hardship. Letting your payments go into default is a good way to do this. Once your creditors understand that you are unable to pay in full, they are more likely to accept a reduced amount as settlement.
Does a debt consolidation loan affect your credit scores?
A debt consolidation loan can affect your credit scores in different ways. First, applying for a debt consolidation loan adds a hard inquiry to your credit reports, which drops your score 3-5 points. But more importantly, consolidating credit card debt drops your credit utilization ratio, which can improve your credit score substantially and quickly.
Utilization is the percentage of revolving credit that you’re using. If you have $5,000 in available credit and your total balance is $4,000, your utilization is 80% ($4,000 balance divided by $5,000 available credit), which harms your credit scores. But if you pay those balances off with a debt consolidation loan, your utilization drops to zero. And if you pay them off with a $5,000 balance transfer card, your utilization falls to 40% ($4,000 balance divided by $10,000 available credit).