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Can Settling Old Debts Lower Your Credit Score?

Published by monica on Sunday, February 10, 2013

Photo credit by Politica11y Unmotivated

Paying off your old debts can negatively affect your credit score. There are some reported instances when people, in order to boost up their credit scores, decided to settle their old debt. To their surprise, instead of improving their scores, it plunged from 85 to 95 points. How can doing something right affect your credit in the wrong way?

Is Credit Scoring a Flawed System?

Because of the unpredictable behavior of the scoring system, borrowers are not assured that settling their old debts will boost their financial standing and make them credit-worthy to lenders. Unscrupulous collection agencies taking unfair advantage of this situation doesn’t paint an encouraging picture.

However, the Fair Isaac Corp., makers of the FICO credit score system, assures the consumer that the incident that happened some years back (a drop in credit score after a recent payment of an old debt), will hardly be repeated today. They have been coordinating with various credit bureaus to create a solution to that part of their system.

Handling of Delinquent Payments and Charge-offs

Credit delinquency occurs after six months of a borrower’s non-payment. After that period, lenders will report it to credit bureaus using another term – a charge-off. Some borrowers mistakenly equate charge-offs as a form of release from their debts. The truth is they don’t free you from any obligation to pay your loan. Lenders and collectors can still go after their money.

Lender will usually turn over delinquent accounts to collection agencies. Your single account will then appear as two entries in your credit report – “charge-off” status for the lender and “in collection” status for the collection agency. Ask the credit bureaus to delete extra entries in case there are more than two.

Old Debts as Seen by Your Credit Score

Credit delinquencies can really put a big dent on your credit score. What matters most to your FICO score is the original lender’s statement on your credit report. Your debt status and balance on the lender’s entry has a weightier effect on your credit score than that of a collection agency.

If you still owed your original creditor some balance in the charge-off, it will be best if you can pay off your debt and ask your lender to reset your balance back to zero.

How Paying off an Old Debt Can Affect Your Score

A few years back, settling an old delinquent account can actually hurt your credit rating because recent payments will update your negative standing in the credit score system. This action makes it appear as though you made your debt settlement just recently. From the credit scoring system’s point of view, your debt settlement has just happened recently. This system’s flawed perception can bear heavily against you.

Settling Your Score with Lending Companies

If you are planning to buy a new house, the lending company will want you to first settle any old account reflected on your credit report before granting you a loan. Credit management professionals will tell you that as part of your settlement negotiation, you should demand that your creditor completely stop from reporting the account or report the account as paid in full rather than merely “settled.”

All in all, you may conclude that settling your old debts can do more harm to you than good. However, you may want to do the ethical thing and repay what you have borrowed.

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