In 1789, Ben Franklin coined the famous line, “In this world nothing can be said to be certain, except death and taxes.” And while many would argue that Mr. Franklin’s quote still holds true today, the impact of a tax lien on credit scores has just become less certain given the recently announced IRS rules.
We all know that Uncle Sam doesn’t take kindly to those who don’t pay their taxes, but what about how unpaid taxes impact your credit and credit scores? What a lot of people don’t realize is that tax lien information is collected by the credit reporting agencies and reported in your credit reports. Further, a tax lien will remain in your credit reports for seven years from the date the tax liability is resolved (paid).
[Consumer Resource: How to Dispute Credit Report Errors]
The specific point impact a tax lien will have on a credit score will depend on the tax lien information reported, as well as any other information contained in the credit report. The impact is greatest when the tax lien is recent and there is no other negative information present in the credit report (missed payments, high credit card balances, etc.). In these cases, the tax lien can drop a credit score by 100 points or more.
The IRS recently announced several new rules designed to help people who are having difficulties meeting their tax obligations—some of which will lessen the impact on credit scores. This rule has the potential to increase the credit scores of a lot of people. In 2010 alone, the IRS filed liens against 1.1 million tax payers (a 550 percent increase compared with 1999).
[Related: 2011: The Year of the Free Credit Score]
The main part of the rule having the biggest potential effect on credit scores relates to the reporting of paid tax liens. Currently, a tax lien that has been paid is still reported on the credit report for seven years from the date the tax liability is resolved. With the new rules, the tax lien will no longer be reported if the overdue tax bill is paid in full, or if the consumer has agreed to a direct deposit agreement to pay the overdue tax obligation on lien amounts less than $25,000. In essence, that piece of history vanishes from the consumer’s credit report and will not factor into credit scores or a lender’s evaluation process.
While I can understand how this would be considered a “pro consumer” change, I can’t help but wonder if this really is the case regarding consumer credit. Research and statistics have shown that consumers with tax liens on their credit reports (paid or not) are more likely to miss payments on other credit obligations in the future compared to consumers with no tax liens on their credit reports. This is why most lenders and most credit scoring systems consider the presence of tax lien information as a negative or derogatory indicator—it’s predictive of credit risk.
The removal of this predictive information could result in consumers scoring higher than they normally would if the tax lien information were reported, and subsequently provide them with access to credit that they may not be able to successfully manage and, in the end, increase the cost of credit for us all.
The bottom line. A credit reporting system that supports full, complete and accurate reporting helps lenders make more informed credit decisions, which ultimately enhances not only your access to credit—but also how much you pay (the cost of credit)—for all consumers.
Image by DrBacchus, Flickr