Debt and its impact on your credit report - How big is it?


Debt determines how your financial life will be in the long run. It determines the types of credit cards you’ll get. It determines how much interest you’ll pay on a home loan. It also determines the amount you have to pay for insurance premiums.

Now, the big question is,
How does debt determine all the aforementioned things?

Well, debt has a love and hate relationship with the credit score. When you keep debts under control, your credit score shines. And when you fail to control your debts, your credit score dooms. Now, this credit score has a big impact on your financial life. Lenders judge your credibility as a consumer based on your credit score. If your credit score is low, lenders charge a high-interest on your loans to reduce the risk factor. On the other hand, if your credit score is high, lenders will complete the loan approval process quickly. They will also charge a moderate interest rate on your loan.

How does debt affect your credit report?

Debts have a direct relation to your credit report.

Debts are reported on your credit report. Both on-time payments and missed payments are reported on your credit report. When you have different types of debt (also known as credit mix) and you make timely payments, positive items are listed on your credit report in the section ‘accounts in good standing.’ When you have different types of debts and you don’t make timely payments, your accounts are sent to collection agencies or charged-off. These are negative items and they also appear on your credit report.

Negative listings stay on your credit report for 7 years and 180 days. Even if you pay off charged-off accounts or collection accounts, they won’t be removed from your credit report. They will stay on your credit report for 7 years and then they will disappear.

How does debt affect your credit score?

The amount of debt you owe has a big impact on your credit score. It makes 30% of your FICO score. If the amount of debt that you owe is more than 30% of the total available credit, then your FICO score will go down.

The ratio between the amount of debt that you owe and the total available credit (also known as credit limit) is called the credit utilization ratio.

Credit utilization ratio - Total debt amount * 100
Total credit limit

When your credit utilization ratio is less than 30%, your credit score improves. And, when your credit utilization ratio is above 30%, your credit score goes down. If your credit utilization ratio is 40%, then it will hurt your FICO score. However, if your credit utilization is 60%, then it will hurt your FICO score even more. Maxed out credit cards have the worst effect on your credit score.

Next comes the payment history. This also has a big impact on your FICO score. In fact, this is more important than the credit utilization ratio. Payment history makes 35% of your credit score. One missed payment or late payment can create a big dent in your score. One missed payment or late payment can pull down your credit score by 90-110 points when your FICO score is 780.

When you don’t make payments to your creditors for several months, creditors can do things against you. They can assign the accounts to debt collection agencies in the hope of getting payments from you. Once your debts are assigned to collection agencies, they drop your credit score by 100 points or even more than that. The higher your credit score is, the bigger the impact.

How do debt relief options affect your credit score?

When you can’t keep debts under control, you can use various debt relief options to tame them. However, there is one fact that you need to keep in mind. Each debt relief option has a significant effect on your credit score.

For instance, if you enroll in a debt settlement program, then you have to pay less than the full amount to creditors. This is because the debt settlement company negotiates with your creditors to lower your payoff amount, waive off the late fees, fines, and charges. So your overall payoff amount gets reduced.

However, debt settlement has a slightly bad impact on your credit score. Since you’re not paying the full amount, so the FICO credit scoring model penalizes you for it.

It’s tough to decipher the exact impact on your credit score. However, with a FICO score of 680 and one late payment, you could lose up to 65 points. Again, with a FICO score of 780 and one late payment, you could lose anywhere between 140 and 160 points.

What do you understand from the above example?

The higher your credit score is, the greater is the drop.

If you opt for bankruptcy as your debt relief option, then also you’re in a soup. Bankruptcy would give you fast debt relief. Chapter 7 bankruptcy can help you to get out of debt within 3-4 months. On the other hand, Chapter 13 bankruptcy can help you get rid of debt within 3-5 years.

Chapter 7 bankruptcy remains on the credit report for 10 years. Chapter 13 bankruptcy remains on the credit report for 7 years. They will remain on your credit report for that specific period even after your debts have been discharged.

How does bankruptcy affect your credit score? Well, bankruptcy can have both a bad and good effect on your FICO score. In the worst scenario, bankruptcy can drop your credit score by 200 points or more.

Again, on a positive note, bankruptcy can increase your FICO score by several points. Most websites highlight only the negative impact of bankruptcy on credit score. They don’t mention the fact that bankruptcy can reduce the credit-utilization ratio and improve the FICO score simultaneously. When all your debts are discharged in bankruptcy, your credit-utilization ratio becomes zero. This is the ideal credit utilization ratio for everyone. Hence, your credit score goes up.

Is debt consolidation a good idea?

Apart from debt settlement and bankruptcy, there is yet another option to repay bills, and that is debt consolidation.
Debt consolidation helps you to repay bills in full. But how does it give relief when you’re repaying bills in full? A very significant and valid question.

In debt consolidation, you indeed have to repay bills in full. But you have to pay it through affordable monthly payments.

How do your payments become affordable? Well, debt consolidation companies negotiate with creditors to lower interest rates on your bills. And, they continue the negotiation process until creditors agree to cut down the interest rate. Once creditors give the final nod, debt consolidation companies ask you to start making payments. The repayment process will continue until all your debts are repaid.

If anyone asks, is debt consolidation a good idea, then one should certainly consider its effect on credit score before giving the final answer. Debt consolidation has a positive impact on the credit score. This is because debtors are paying bills in full, unlike debt settlement and bankruptcy.

How to minimize the harmful effects of debt on your FICO score

While it’s true that debts can pull down your FICO score when they are uncontrollable, there are plenty of ways to minimize the negative impact. For instance, even if you can’t clear the outstanding balance, you should try to make minimum payments at least. Watch out for the ways to raise your income so that you can make additional payments on your debts. This is the only way to lower your credit utilization ratio.

There is yet another step you must take to safeguard your credit score. You shouldn’t incur fresh debts by any means. You’re unable to repay your existing debts already. How will you pay off new debts? They will only increase your credit utilization ratio and lower your credit score even further.

Don’t apply for too many loans within a short time. It will trigger hard inquiries and pull down your credit score by 5 points. Usually, 5 points don’t matter a lot. However, if your credit score is 700, then it does matter for you. A 5 point drop will take your credit score in the 600 bracket.

Conclusion

Don’t get scared just because you have debts because there are options to control them and safeguard your credit score. There are various debt relief options to reduce your financial burden. Read the modus operandi of each debt relief option and its effect on your credit score before making any decision. That may help you to make the right decision.

If you can’t pay off the outstanding balance anyhow, then you can request your creditor to increase your credit limit. If your creditor agrees to grant your request, then there is no problem. However, if the creditor refuses to hike your credit limit, then you’ll be back to square one. So, there is no guarantee that this strategy will always work in your favor.


Stacy B Miller 
Debt and its impact on your credit report - How big is it? Debt and its impact on your credit report - How big is it? Reviewed by PANDA PRO on February 24, 2020 Rating: 5
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