After job loss leads to debt, rebuild your credit score
Focus on adding positive new entries in your report
Dear Credit Care,
I have about $10,000 of 2-year-old credit card debt from loss of job and my credit score is now dismal. My creditor has turned the debt over to a collection agency and offered to settle the debt for about 50 percent of the amount owed. Will this settlement help my credit score? How will it reflect on cleaning and boosting my score back up? -- Brandon
Unfortunately, the damage to your credit score was done when you were unable to make payments on your credit card debt as agreed. Making payment in full or settling the debt at this point will not substantially improve your credit score. The reason your credit score will not improve by paying the accounts is because your score is calculated based on the information included in your credit reports and is designed to assess credit risk. The negative information regarding your credit card accounts that were not paid and turned over to collections is currently reported on your credit report and will continue to be reported for seven years from the first date of delinquency (typically 180 days after last payment was made). It may seem unfair, but when determining credit risk, which is what your credit score reflects, past behavior is what is evaluated.
So, because it will not make a significant difference in your credit score, I recommend that you make the decision about settling your credit card debt based on what is best for your current financial situation rather than how it will affect your credit score. Future lenders are going to want to see that you paid what you owed on these accounts. Settling the accounts is an acceptable, albeit not the preferred, resolution for payment.
Should you have the money and decide to settle the accounts, be sure you have the settlement agreement in writing before you make payment. Also, if you settle for $5,000 and owe $10,000, the forgiven debt of $5,000 is considered income by the Internal Revenue Service, which means you may have to pay income taxes on the forgiven amount. Keep copies of the settlement agreement so you can prove that the accounts were paid just in case you are contacted in the future regarding the accounts.
Improving your credit score will come with time and positive information added to your credit reports. More weight is given to the most recent activity on your credit reports, so the more time that passes, the less of an impact the negative credit card accounts will have on your credit score. To increase your score, you will need to have regular positive information being reported on your credit reports. If you do not have any positive current accounts, you will need to establish some. Obtaining new credit with a low credit score can be tough, but you do have options.
You may consider a secured credit card to re-establish credit after a financial crisis such as an interruption of income due to a job loss. Be sure the card issuer reports account activity to the three major credit bureaus. You might also consider a card that automatically converts to a nonsecured card after a defined period of monthly on-time payments.
It is important to remember that your credit history will often reflect what is going on in your life. Your credit was negatively affected when you lost your job. To help minimize the financial impact of future life events, begin an emergency savings account of at least six months of living expenses. Having a cushion to help you through unexpected expenses and income losses may help you keep your credit score intact next time.
Handle your credit with care!
See related: Report forgiven debt to the IRS on a form 1099-C
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