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How Getting Out of Debt Can Hurt Your CreditA common concern you may have when searching for the best debt relief solution is how it will impact your credit score.

There are many misconceptions about credit reports and the harm that comes from credit counseling, settling debt for less than what you owe and bankruptcy.

Your credit report and credit score will heal and bounce back over time, and you may even be surprised by how quickly your financial future looks bright again.

First Things First: Debt Is the Priority

If you’re considering debt relief options, you’re not in a good position to spend, or to be seeking out new credit products now, or for a couple of years to come.

The three most legitimate debt relief intervention options do indeed impact your credit report and/or credit score. Each method will hurt your ability to get new loans, or certain types of loans, for the near future. That’s OK, it’s a part of the process. Your credit score should come second to your focus on getting out of debt right now.

I am going to lay out the ways your credit report, credit score, and future access to credit products will be affected by debt relief programs. Each comparison is generalized, but in a way that will help you compare your credit needs for the next three years.

Debt Management Plans via a Credit Counseling Agency

Your accounts that are accepted into a credit counseling agency’s debt management program will be closed. These previously active credit card trade lines will be updated on your credit report to show that the account was closed by the credit grantor (unless they were already closed, or you get proactive and close them yourself prior to enrolling with a credit counseling service). Closing active credit accounts can have a negative impact on your score.

While enrolled in a credit counseling program, it is generally very tough to get financing of virtually any nature in the first 12 to 24 months. This is because many creditors will inform the credit reporting bureaus that your account with them is enrolled in a structured debt repayment plan. Because credit counseling agencies will normally want to have all of your credit card debts enrolled in the plan, this type of reporting will likely appear several times across your credit report.

Debt management programs with credit counseling companies run 4 to 5 years, on average. This can mean you are locked out of new unsecured credit products, like new credit cards, for this entire period of time.

You may be able to get financing on a vehicle or even purchase a home, modify an existing mortgage, or qualify for a student loan (either your own or parental) after the first 1 to 2 years of making on-time payments in the debt management plan.

When you complete the debt management plan, and if all other payments were kept current (like an existing mortgage, student loan, car loan), you should find that your credit score stayed in good shape. You will have eliminated most, if not all of your unsecured debt, after working with the credit counseling agency. But you will have also eliminated years’ worth of unsecured credit history, and have no recent unsecured credit activity. Recent credit activity is one of the most important parts of your credit report you’ll need to rebuild.

[Related Article: The First Thing You Must Do Before Paying Off Debt]

Free Credit Check & MonitoringSettling Debt for Less Than You Owe

Settling your credit card debt for less than you owe requires you to have missed payments. This fact will give many readers pause if you are still making your payments on time. If you are reading this and are already 90 or more days late, and cannot afford a debt management plan with a credit counseling service, your options for debt relief could be limited to bankruptcy or settling debts.

For those readers who have not missed credit card payments yet, but know that you will soon fall behind, missing payments is how you set yourself up to settle later. However, missing payments will:

  • Cause your credit score to fall significantly
  • Stain your credit report with late pays, potential charge-offs, and can lead to later debt collection entries for 7 years.

How debt settlement impacts your credit report and credit score will vary widely from one person’s situation to the next.

Since another major portion of your credit score is factored on repayment history, your credit is going to take a dip from using this debt relief strategy. The duration of the credit pain will be different for each person. But once you achieve zero balance reporting, your credit score can begin to improve. How long it will take to improve will depend on several factors:

  • How long it takes to settle your debts. Settling a credit card debt directly with your lender before the account goes 180 days without payment is best.
  • Did your account get sold to a third party who is now reporting a collection entry on your credit report? This means your original lender reports your debt as a charge-off, and the debt collector reports a new entry on top of that.
  • What accounts were current during the settlement process? Those who settle credit card debts while keeping current with their payments on a mortgage, car loan and student loans tend to see their credit bounce back quicker.
  • Did you have much credit depth before settling debts? Those with paid off home loans, auto leases and loans, paid off credit cards etc., tend to recover faster than someone whose only accounts in their credit profile were the credit cards that got settled.
  • Were you able to take smart steps to improve your credit along the way? There are indeed ways to cherry pick accounts you settle, or pre-plan your settlement strategy in order to improve your access to credit products sooner.

In my experience of more than a decade of working with people to resolve debts by settling balances for less, I see peoples’ credit scores and access to new credit products recover in 12 to 18 months, on average. This would be a year to a year-and-a-half after the last account gets settled and the credit reports are updated to reflect that there is no longer any balance owed. By “recover,” I mean you are in decent credit shape again in order to qualify for home loans, auto leases and loans, and even new credit cards.

I have worked with people who, after completing settlements, have been able to get Federal Housing Administration underwriting on a home loan, funding for student loans and new auto financing much earlier than would have been the case had they filed chapter 13 bankruptcy, or enrolled with a credit counseling agency.

A key factor for bouncing back from settling debts and accessing new credit comes from a healthier debt-to-income ratio. Your finances now reflect that you can take on new debt and successfully make payments with your income.

[Related Article: The First Thing to Do Before Applying for a Credit Card]

Chapter 7 Bankruptcy

Chapter 7 bankruptcy stays on the public record section of your credit report for 10 years. That is the longest shelf life of all debt relief options, but the long negative credit reporting and the initial Olympic ski slope credit score drop is misleading. The perception of chapter 7 bankruptcy is that your credit is being sentenced to prison for 10 years. Not true!

If you are struggling under a heavy debt load, and can qualify for Chapter 7, it should be viewed as a viable debt relief option, not one that should be avoided at all costs. In fact, Chapter 7 bankruptcy, viewed purely from a cost basis, can beat the cost of debt settlement and credit counseling for the vast majority of people.

People discharging debts through Chapter 7 bankruptcy find credit card offers in their mail within weeks or months after the bankruptcy is finalized. The credit card offers do not come with high limits, and are going to have higher interest rates attached, however.

Bankruptcy wipes out your credit card debt, and for many this means a healthier debt-to-income ratio than they have had in years. Creditors know you cannot file Chapter 7 again for 8 years, so they’re more apt to lend again.

Here is some additional access to credit and loan standards that you need to be aware of when filing Chapter 7 bankruptcy:

  • FHA underwriting for new home loans will put qualifying for a new mortgage or home purchase out of reach for a minimum of two years.
  • Underwriting for student loans, either ones you take out personally, or co-sign for, will be out of reach for a few years following a Chapter 7 bankruptcy.
  • You may be able to get auto financing within 12 months after filing for chapter 7 bankruptcy. But be prepared to pay a higher interest rate for the loan.

Chapter 7 can actually be a necessary beginning to a new credit life. You simply need to know how lenders and underwriters view the bankruptcy, and be proactive and smart with rebuilding credit. The 10-year credit report stain is more like a coffee cup smudge within two to three years.

Chapter 13 Bankruptcy

Chapter 13 is the worst of all debt relief solutions when it comes to its impact on your credit. The court trustee is going to be overseeing virtually every aspect of your financial life during your repayment plan. Chapter 13 bankruptcy plans go for either 3 or 5 years. The majority are 5-year plans.

The bankruptcy itself will be on your credit report for 7 years. The bankruptcy trustee will have to approve and monitor your household budget and expenses for the life of the Chapter 13 repayment plan. If you wanted to take on virtually any new credit, you have to get the trustee’s permission, and that is not very common.

If there is any debt relief solution that is like a jail sentence to your credit, this would be it. There is really no flexibility to a Chapter 13 bankruptcy. Historically, a majority of chapter 13 filers cannot, or choose not to, stick it out.

There are very real benefits to a Chapter 13 bankruptcy, however. You do get the court’s protection from creditors who would otherwise use aggressive collection strategies to get repaid. If you cannot settle with creditors, hold too much equity in your home to qualify, or have other assets to protect, Chapter 13 will make sense for you financially. But from a credit planning perspective, it has the most severe impact for consumers.

[Credit Score Tool: Get your free credit score and report card from Credit.com]

Looking Forward

Hopefully you are now better prepared to understand that when you are struggling with debts you can no longer afford, but are more concerned with your credit score, your attention is on the wrong thing. Focus on solving your personal debt and budget crisis first. Credit will be available again, and much quicker than you may have thought.

Focus on the debt relief solution that is in line with your current financial ability, but with an eye on your future credit goals and needs in the next two to three years.

Ask yourself this question: “Do I have an urgent credit issue, or a serious debt problem?”

Check out Credit.com’s free Credit Report Card for an easy-to-understand overview of your credit history, including your scores, and how you compare to others in your state and the country.

Image: iStockphoto

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  • http://frugalguruguide.com/articles/ Jenny @ Frugal Guru Guide

    Getting out of debt through paying off your debts doesn’t hurt your credit score, however. It’s missing payments or DEFAULTING on all or part of your debt that causes problems.

    Once you’re out of debt, don’t cancel your credit cards. You can cut them up if you don’t think you can control yourself, but don’t cancel them, and your credit score will be better than ever.

    • Michael Bovee

      It is true that conventional wisdom for how to get out of debt should be looked to first. Using a debt snow ball, or debt roll up strategy, coupled with spending discipline and frugal choices, is a great method for debt relief. And you preserve your credit.

      Many people who run out of money before they run out of month find themselves at a place where their credit score, even if still healthy, has lost it’s utility function. No credit is available, and taking on additional debt means digging a deeper hole.

      Planning around future credit needs when you need debt relief is just smart. Placing too high an importance on a credit score when bills cannot be maintained is harmful.

  • Jade S

    Prior to 11/2011 my FICO’s where in the low 700s. I had a great handle on my credit. On 11/28/2011, I had a Small Claims Judgment for $1485. The court did not place the judgment on my CR;( the person I owed the money did) an ex-friend 30 days prior to my right to file an appeal. Well, the judgment was paid in full. I have not submitted the Judgment Settlement form to all CRA.

    In addition, the court says I can request for this Small Claim Judgment to be vacate the judgment due to the Judgment Creditor placing the judgment on my CR without waiting the Mandatory 30 days.

    Also Victim of IRS Identity Thief in 2011; IRS verified and I have a stamped letter from Feds acknowledging someone else filed my taxes and tried to open up credit under may name.

    Question: Should I challenge the Judgment (Paid off) via my Identity Thief status, just have it marked as paid or dispute the judgment being placed on my CR prior to Court Mandated 30 grace period. Thanks

    • Michael Bovee

      Jade – Dealing with the judgment at its source (the court record) would be best. Getting it vacated provides finality. I am a bit skeptical about how successful you will be in getting this accomplished though.

      If you are unable to get the judgment vacated, you should certainly take action to get your credit reports, and the court record, to reflect the judgment is satisfied.

      It does not sound like this debt was the result of the identity theft issue you had. If it is, you certainly should make every effort to get this corrected.

      If it is a legitimate judgment, it will show as satisfied in the public record section of your credit report until it ages off. It will have less of an impact on your ability to access credit at fair prices over time.

  • andrew miller

    looking for some help with my debit problems

    • Credit.com

      Andrew – depending on your current situation, there are several options to consider. This article is a great resource and will explain the different options for dealing with debt before it gets too far out of control:
      How to Avoid a Debt Spiral

  • Anna A

    I had paid off 3 of my student loans and left 1 opened with an amount of $5000. I only have 1 revolving account with Macys. I have 2 collections that will be gone by nxt year (after 7 years). How can I improve my credit score? I’m planning to open a secured credit card with FirstProgress. Is it the best move I should do?

  • http://yahoo darryl

    Question; I’m 3yrs in a5yr chapter 13 filing , can I still refinance my current home loan for a lower interest rate or do I have to wait until my chapter 13 filing is resolved. thanks.

  • Michael Bovee

    Hi Darryl – You will have to locate a lender willing to refinance your loan while you are still in your chapter 13. You will also need to get the bankruptcy trustees permission. If you proceed without the trustee, you could jeopardize completion of the 13 plan.

  • http://consumerrecoverynetwork.com/ask-a-question/ Michael Bovee

    Greg – Follow the tips outlined in this article for cleaning up your credit: http://blog.credit.com/2013/02/a-step-by-step-guide-to-disputing-credit-report-mistakes/

    How long have you been making payments with the chapter 13 plan?

    • Greg K.

      I will be into the 3rd year this coming March. By the way, great article.

      • http://consumerrecoverynetwork.com/ask-a-question/ Michael Bovee


        So a little more than 2 years to go from here. It is great that you are taking proactive steps about your credit early.

  • http://www.Credit.com/ Gerri Detweiler

    It’s an 11 year old debt. I see no reason it should – or could – show up on your credit reports now. But I have to ask – what is your goal in paying it now? It’s likely outside the statute of limitations and if you do pay it you may restart that time period.

  • CR

    How about if I just negotiate with my credit card? they are offering a way lower APR than the debt management company.

    • http://www.Credit.com/ Gerri Detweiler

      If that’s the only card you have, then it’s no problem. If you were going to put multiple cards in the program then discuss it with the debt management company.

  • CR

    How about if I am getting a better deal from my credit card than the loan modification company? Yes I still need to close the credit cards but the payment APR is way better.

    • http://www.Credit.com/ Gerri Detweiler

      If that deal is better in the long run then it sounds like you should take it. The one scenario I caution about is when someone has multiple cards and only one of them will work with them on a hardship plan. In those cases, it’s sometimes better to get everyone on board even if each individual offer isn’t the lowest.

  • http://www.Credit.com/ Gerri Detweiler

    The Chapter 13 will be reported 10 years from the filing date. Hard to say what will happen with the medical bills. They may wind up in collections or they could even sue you. Or they may see the filing and not realize your case was dropped and leave you alone. You’ll want to make sure you know what the statute of limitations is for these debts. For reference, see: Statute of Limitations On Debt Collection by State

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