There are many ways people are led down the wrong path for debt relief due to an emotional attachment, or legitimate financial need, for maintaining your credit score and a healthy credit report. There is a host of incorrect and incomplete information about how using a credit counseling agency, settling a credit card debt for less than what you owe, or how filing bankruptcy will affect your credit rating, or prevent you from accessing new credit.
One of the biggest concerns for Americans who are struggling with debt, and looking for solutions to get out of debt, is their credit score. The question that I’ve heard most frequently over the years of working and consulting with consumers is; what will “this” do to my credit report? My answers are generally pretty enlightening, and because there are so many misconceptions, and even people willing to mislead in order to sell you on some approach, I want to lay out some facts about the top 3 debt solutions and how these 3 methods to resolve debt may impact your credit score, or how and when you may be able to access new credit products again.
Credit and lending – The new normal.
Risk aversion by lenders in the extension of credit has returned with a vengeance! This means that if your DTI (Debt to Income) is unhealthy, you will frequently find that additional credit is unavailable to you regardless of your credit score. Many people are finding that existing credit lines are being cut down to current balances and unused accounts are being closed. There is much more to discuss on this topic, but for the consumer struggling with debt my point is; stop thinking about your score. Additional credit availability is unlikely right now, anyway.
The credit score has been so indoctrinated into our consumer based society; people make irrational decisions, negatively impacting themselves and their families, all in the name of the all mighty FICO score. So, as if through a megaphone from 10 stories below; “Put down that credit report and step away from the ledge”!
If you’re struggling with debt, whatever the hardship, and are forced to consider your debt relief solutions, here are the 3 most popular options and how each hurts your credit score, and stains your credit report.
Debt Management Plans (DMP sponsored by a nonprofit credit counseling agency) and your credit score:
Your accounts that are accepted into the program will be closed and this will have a slight impact on your score. While enrolled in the program, it is typically very tough to get financing of virtually any nature in the first 24 months, due to the DMP notation in your credit report, next to each of the accounts enrolled. Debt Management Programs run, on average, 5 years. You are basically in “unsecured credit purgatory” for this entire period (such as obtaining new credit cards). You may be able to get financing on a vehicle or even purchase a home, modify an existing home loan, or qualify for a student loan (either your own or parental) after the first 2-3 years of successful participation in your credit counseling repayment plan. When an account in your DMP is fully paid, the DMP notation is removed.
This is a good option, if the math supports your finances (more on the math in a moment).
Filing bankruptcy and the impact to your credit report and credit score:
Chapter 7 bankruptcy – will stay on your credit report for 10 years. This does not mean you won’t have access to credit for the full 10 years! This is one of the biggest misconceptions out there, and partially what motivated me to write this. There are many reasons to try to avoid bankruptcy. Your ability to get credit in the future is one of the flimsiest. Up until the economy started crashing in 2007, consumers who discharged debt in a chapter 7 were finding unsolicited credit offers in their mailbox within 6-12 months of discharge. The credit offers were generally subprime, so not the best limits and rates, but were offered nonetheless. With the return of risk aversion, and many of the sub prime credit card issuers having left the market, I don’t see these solicitations for credit just outside of bankruptcy being offered much, at the time of this writing. I find them even less likely moving forward, as banks will be repairing their balance sheets for years to come. Besides, having just obtained discharge of unsecured debt, one should not be in a hurry to obtain more, and most certainly not at subprime rates.
Current FHA underwriting standards mean you will not qualify for FHA funding after filing bankruptcy for a period a 2 years. It is, therefore, unlikely you will get a loan for a home purchase in this time frame, in the current loan market. Student loans are generally off the table for a few years, including ones you would apply for in order to assist your child. You may be able to finance a vehicle purchase after a chapter 7 within 12 or so months after discharge.
Your credit score is factored on several data points. 35% of it is reportedly factored on utilization/Debt to income (DTI). After discharging debt in a chapter 7, your DTI and utilization should be fabulous. Now, you wait out some of the 2-3 year timelines lenders and underwriters use as a standard, take a few effective steps to rebuild credit, and this whole 10 year misconception is seen for the baloney it is.
Chapter 13 bankruptcy – is totally different. It’s the worst of all options for credit and access to credit. The court is overseeing a repayment plan of 3 or 5 years. It’s on your credit report, you’re on a court approved household budget, and if you were to seek a new credit contract of virtually any type, you must first get approval from the court appointed trustee, who has been empowered to tell you “NO”. This version of bankruptcy is credit purgatory. It is rigid and inflexible. You will have court protection from creditors, but at the highest cost. It is an option, but should be seen as a last resort.
How settling credit card debt damages your credit report and lowers your credit score:
Settling debts for less than the balance requires you to be behind in payments. Since another 35% of your credit score is factored on repayment history, your credit report and score is going to get clobbered! The clobbering itself and the duration of the pain will be different for each person. Once you achieve zero balance reporting, your credit score will begin to improve. How long it will take to improve will depend on several factors, such as:
- How long you went delinquent before a zero balance was reported
- Was the account charged off (settling debt inside of 6 months delinquency is optimal)
- Was it sold after charge off and re-reported (original creditor reports the charge off and the debt collector reports as well)
- What accounts were current during the settlement process (mortgage, car payment, other)
- What was the depth of your positive credit history (have you had cars, mortgages etc… paid off in the past)
- Did you take prudent steps to rebuild credit along the way
My experience has shown that roughly 18 months after completing the last settlement, and the zero balance due reporting, you’re in decent credit shape again, when contemplating legitimate needs. I have seen CRN members qualify for FHA funding on a new home purchase 9 months after finishing their settlements (focusing on the above 6 items) . The primary reason for this is that your debt to income is in better shape, and the math shows you can comfortably service the mortgage. This aspect should be considered by those who have been turned down for a modification on an existing home loan based on their DTI, and who have resources that can be creatively deployed.
Here is a brief video about debt relief and your credit rating to help put things in perspective.
All debt relief programs impact your credit report and your credit rating:
These 3 debt relief options are what a consumer, who cannot keep up with payments, has to consider. The fact is; every one of them is going to hurt your credit score, or access to new credit. Even just slogging along and struggling to meet your minimums is going to keep you from any new credit based on a poor DTI ratio, regardless of the FICO score. The days of fog a mirror – and get credit – are gone.
Basing your decision on which option to go with because of the affect on your credit report, is like arguing over whether to punch a one foot or two foot hole in the bottom of the boat while at sea. The boat sinks no matter what.
These 3 options actually track pretty well when you boil them down to which one will put you in position to obtain legitimate loans, like a home/car purchase or student loans, the quickest.
The point is, when you are drowning in debt and are worried about your credit score, you’re worried about the wrong thing.
The media, lenders, regulators, unwitting commentators, have all contributed to the credit score hype. Sure, it is important when you are out shopping for loans and better interest rates, but that’s not what someone who cannot keep their payments up should be thinking about. They are not going to get credit, and they cannot service the additional debt anyway. Anyone saying something different is talking up their book, has the luxury of not struggling with debt, or is a pump monkey for some special interest.
When determining which debt relief solution will best suit your current situation, and you’re mid-to-long term goals, always start with the math. The math doesn’t lie and should assist you in narrowing down which option is best.
Chapter 7, for those who qualify, and who fully understand all of the implications associated with filing (sans the credit score), will provide the quickest, most thorough relief.
Other than a discharge through bankruptcy, my experience would suggest that consumers weigh and compare a debt management plan with a credit counseling service beside a debt settlement approach. Then make a rational decision based on the math and the flexibility that is built into either option. Settlement will generally win this test due to the flexibility it has that a DMP or chapter 13 does not.
When doing the math to qualify for a credit counseling program, you will need to factor your ability to consistently and comfortably make a monthly payment of 2.2% of your current unsecured credit card balances. If you cannot, or are concerned with your ability to maintain this type of payment, I question why you would even start working with a credit counseling agency. You have a high probability of not completing the DMP and will have wasted resources that would have contributed to your success using a settlement approach and the ability to regain your financial freedom sooner.
If you are considering debt settlement, be sure to consider the hype and fees associated with how debt negotiation is sold to those looking for some hope to avoid bankruptcy. Please read: Debt Settlement Marketing-The gist, The Juice & the lies or Dude Meets Debt Wall
If you have hit the debt wall and want to learn about all of your debt management options in detail, including debt settlement, while workign one on one with a pro, consider enrolling as a CRN member. Learn more about membership. Consumer Recovery Network offers debt help with no risk to you.
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