USA   |   UK   |   Australia   |   Canada
ADVERTISEMENT

How charge-offs work, how they affect your credit

By Gary Foreman

The New Frugal You
New Frugal You columnist Gary Foreman
Gary Foreman is a former financial planner who currently edits The Dollar Stretcher website and newsletters. He writes "New Frugal You," a weekly Q&A column about frugal living, for CreditCards.com

Ask a question.

'New Frugal You' archive

Question for the CreditCards.com expert

Dear New Frugal You
I often hear the phrase "charge-off" used in discussions about credit cards and credit scores. I don't understand what it is. Could you help explain it and how it affects me? -- Confused in Carolina

Answer for the CreditCards.com expert Dear Confused,
You're exactly right! You are hearing much more about charge-offs lately. And, the term can be a bit confusing if you're not familiar with accounting or financial jargon. Let's see if we can't shed some light on the subject.

There's a reason charge-offs are in the news. According to the Federal Reserve, banks reported that in the second quarter of 2011, a bit less than 2 percent of all loans and leases have been charged off, as has a bit less than 6 percent of all credit card debt. While those levels are down sharply from 2009 and 2010, they're still much higher than they were before the recession.

Let's discover what a charge-off is and is not. A charge-off is an accounting entry. A bank or other lender considers your debt to be an asset. It's an asset because it has value. But if you get behind in your payments, the value of that asset falls into question. And, after a while, the IRS requires the bank to remove your loan from its assets. The bank then "charges off" part or all of your loan from its books.

So a charge-off is an accounting activity. It also is a report that goes to the credit bureaus and gets incorporated into your credit score. If you have a loan marked as charged off, it will hurt your credit score. A charge-off will remain on your credit report for seven years.

What it is not is a release from your debt. Even if an account is charged off, you still owe the money. And, as it turns out, it may even make it more difficult to repay the debt afterward.

Charge-off aftermath
Here's why. When a bank charges off a debt, it will typically do one of three things:

  1. Try to collect the debt itself.
  2. Hire a collection agency to collect for them.
  3. Sell the debt to a collection agency.

You have no control over when a debt is charged off. That's determined by law and the lender. Even if you have every intention of repaying the loan, it may still be charged off. A credit card account is usually charged off when the customer fails to make minimum payments for 6 months.

As we mentioned, this action will hurt your credit score. Thirty-five percent of your score is based on your payment history. Any late payments will lower your score. So the charge-off hurts, but most of the damage has already been done by the late payments. The higher your score was to start with, the greater the damage will be.

Debts still worth paying
Once a debt is charged off, it will be tempting to not to pay it even if you have the money to do so. You may want to reconsider for two reasons.

First, by paying the debt, you can change the status of the account to "charged off, paid." That tells other future lenders that you make every effort to repay, even if it's hard to do so. That status looks much better to lenders than a status of just "charged off."

Second, if you negotiate a debt settlement (paying less than you owe), you could find yourself owing taxes. Any time a lender forgives a debt of more than $600, it is required to notify the IRS and the forgiven debt is added to your taxable income for the year.

If that does happen, you may qualify for an exemption. The exemptions are fairly generous. See a qualified tax preparer to be sure.

I hope you're not behind on any of your bills and the question about charge-offs is just because you're confused. Yet, even if that's the case you'll still be affected by charge-offs.

The credit card companies estimate how much they'll lose to charge-offs. And they charge everyone higher fees and interest rates to cover those losses. So everyone who uses a credit card will pay a little extra because of charge-offs.

For the next year or two, we'll all continue to hear more about charge-offs. It's an unfortunate side effect to a tough economy and the large amount of consumer debt outstanding.  

See related: Repaying charged-off debt, Debt negotiation in three (not) easy stepsHow many points off? FICO reveals how common credit mistakes affect scores

Published: August 25, 2011



Join the discussion

We encourage an active and insightful conversation among our users. Please help us keep our community civil and respectful. For your safety, do not disclose confidential or personal information such as bank account numbers or social security numbers. Anything you post may be disclosed, published, transmitted or reused.

If you are commenting using a Facebook account, your profile information may be displayed with your comment depending on your privacy settings. By leaving the 'Post to Facebook' box selected, your comment will be published to your Facebook profile in addition to the space below.

The editorial content on CreditCards.com is not sponsored by any bank or credit card issuer. The journalists in the editorial department are separate from the company's business operations. The comments posted below are not provided, reviewed or approved by any company mentioned in our editorial content. Additionally, any companies mentioned in the content do not assume responsibility to ensure that all posts and/or questions are answered.

Three most recent New Frugal You stories:

Share This Story




Follow Us!


Credit Card Rate Report

Updated: 10-31-2014

National Average 15.09%
Low Interest 10.37%
Balance Transfer 12.82%
Business 12.85%
Student 13.14%
Cash Back 14.98%
Reward 15.07%
Airline 15.46%
Bad Credit 22.73%
Instant Approval 28.00%

ADVERTISEMENT
ADVERTISEMENT