Credit can sometimes feel like a case of “damned if I do, damned if I don’t.” If you pay off debt and close an account, you’ll likely see a dip in your credit score. But if you continue to let debt pile up — or only make minimum payments — your credit score will drop then, too.
Make no mistake: paying off debt is a good thing in the long run. Unfortunately, severe debt is often only resolved through consolidation, settlement, or bankruptcy, all of which can bring down your credit score.
So, what’s the solution? What’s the best way to pay off your debt? Is it really worth it to live debt-free? Let’s take a look.
How Debt Affects Your Credit Score
First, it’s important to understand debt’s relationship to your credit score. Many people assume that less debt = a higher score. That’s not quite true. Your credit score also reflects the length of time you’ve been using credit, as well as how much credit you have available. Lenders like to see that you’ve been responsibly using credit for years.
That means that when you pay off and close out an account, your average account age drops. And if that account was a revolving-credit account, such as a credit card, closing it means that your available credit drops. In turn, so does your score.
Ideally, then, you have a mix of credit accounts: some revolving and some “installment” (e.g. your auto loan). You may want to keep some older accounts open yet use very little of them. For that reason, some consumers will maintain one credit card that they pay off every month to avoid interest rate payments, as well as a fixed-amount loan such as a mortgage.
How Much Does Debt settlement affect your credit score?
If your debt is crippling you to the point that you cannot afford your basic expenses, now may be the time for extreme measures. Debt settlement services will negotiate with your creditors to possibly allow you to pay a lower amount in exchange for closing the account. There are also debt consolidation providers that will issue you a new line of credit so that you can pay off your loans with one monthly payment.
There are definitely negative effects to both these methods. As we mentioned, closing your accounts will ding your score. Debt settlement always involves closing accounts in exchange for a lower payoff amount. This also often means you’ll never be able to open an account with that provider again.
Also, many debt settlement companies suggest that you stop paying while they negotiate. That’s because most lenders won’t settle unless they’re seriously worried that you won’t pay them back. Unfortunately, this is dangerous advice: late payments have a huge negative impact on your score and will remain on your report for a whopping 7 years. Try to maintain payments until a settlement is reached, and only use debt settlements for debts that are already severely delinquent.
When you settle, your account will be noted on your credit report as such. Future lenders will see that and be less inclined to grant you credit. Ideally, you pay off your debts in full, which in time will boost your score. If you are not able to pay your debt obligations, however, debt settlement is a good option for large debts that are at least one year past due. At that point, the score dip will likely be worth it to resolve the effects of delinquency.
Debt consolidation involves opening a new installment account, which immediately increases your debt burden and comes with a hard inquiry — both of which drop your credit score. So if you choose this option, don’t be surprised if your score drops even though you’re continuing to pay off your accounts.
Either way, these methods are preferable to carrying on with monthly debt balances that you cannot afford. Ultimately, late payments and delinquency have a much larger impact on your credit score — so don’t worry too much about a score drop from settlement or consolidation if either of them allows you to escape the debt cycle. That said, consolidation or debt settlement can be worth it depending on your own financial situation and goals – always do your research first.
How Will Filing Bankruptcy Affect My Credit Score?
Bankruptcy can seem like an easy way out of your debt burden, but it is the nuclear option. It will have a major impact on your credit score and remain on your report for up to 10 years, which can make it very difficult to obtain future credit, including auto loans and mortgages. It can also scare off potential landlords and employers who run a credit check.
When you file for bankruptcy, you work with a lawyer who will help you make a case that you cannot meet your debt obligations. Creditors will then release you from your debts and close all accounts. However, it’s not that simple. You will often be asked to sell any assets to help cover the debt, and proving that you qualify for bankruptcy is anything but easy.
There are two types of bankruptcy: Chapter 7, in which you sell certain assets and give the proceeds to your lenders in exchange for zero debt obligation, and Chapter 13, in which your debts are reorganized so that you can pay them off in 3-5 years. It may be easier to qualify for Chapter 13, but you will still take a hit to your credit score.
A bankruptcy sends a strong message to potential lenders that you are a high-risk borrower. While this may not concern you if you don’t intend to use credit cards ever again, keep in mind that bankruptcy and the resulting decline in your credit score can impact your ability to buy or rent a home for up to 10 years afterward.
The good news is that even bankruptcy does not stay on your credit report forever. Chapter 7 bankruptcies are removed after 10 years and Chapter 13 bankruptcies after seven. During that time, you can still rebuild your credit. Try using a secured credit card or a bill-reporting service such as Experian Boost while you recover from bankruptcy.
How Long Does It Take To Improve Your Credit Score?
As a rule of thumb, most negative items on your credit report will remain for 7 years (Chapter 7 bankruptcies for 10). Their presence will drag down your score. However, you can see a fairly quick improvement to your score by reducing the amount of credit you’re using and keeping your oldest account(s) open with a zero balance.
In time, regular on-time payments for a good mix of credit accounts will boost your score. Delinquencies and bankruptcies will eventually fall off. However, if you close all your accounts, your score may stay low even if you’re debt-free. That’s because credit bureaus are also evaluating how much good credit history you have.
So, if you choose debt settlement or consolidation, be strategic about your credit use. Ideally, you reduce your various types of debt obligations so that you can live with less stress, but you can still obtain a mortgage, auto loan, or business loan. Keep a credit card open with which you can make recurring purchases and pay it off in full each month. This boosts your credit score while sparing you the cost of interest or threat of delinquency.
Is Being Debt Free Worth It?
All that said, being debt-free opens a lot more opportunities to you, both financially and otherwise. “Debt-free” typically refers to living without credit card debt; again, there is nothing wrong with having an open credit account or a mortgage if you make regular payments. Your main goal should be to use credit responsibly and avoid interest. To do that, try to carry a 0% balance for revolving accounts and make your installment payments on-time.
As we noted, becoming debt-free can make your score drop, whether due to closing an account, reducing your available credit, or using settlement or consolidation. So, be prepared to wait a few months up to a year before your score increases enough to qualify you for a mortgage or auto loan. It pays to plan ahead: make a goal to become debt-free by a certain time so that you can access the loans you need. In any case, the temporary dip to your score is always worth your long-term financial health.
What Is It Like To Be Debt Free?
People who live debt-free tend to be better able to handle drastic life changes or emergencies. Rather than losing much of their monthly income to debt payments, they can save that money for an emergency fund and be prepared for a “rainy day.”
Living debt-free also gives people the freedom to travel, donate to charity, invest in startups, and do other things that contribute to their wellbeing as well as society at large. Rather than lining the pockets of big lenders, they can support small businesses and their families.
Plus, without a heavy debt burden, people are better able to launch a side hustle, found their own company, or do other activities that generate income. When they need it, they can more easily obtain a business loan to support these endeavors because they have good credit.
A debt-free life is one in which you call the shots for your financial health. You can make the right choices for your goals and well-being, rather than suffering the daily stress of wondering how you’ll pay back your creditors.
Being Debt Free Has It’s Benefits
When evaluating your options to settle or consolidate debt, or if you’re considering bankruptcy, it’s important to weigh the short-term effects against the long-term benefits. Sometimes, a strict budget and making some sacrifices to pay down your debt faster is the best course of action to meet your financial goals. In situations where you cannot breathe due to your debt burden, though, the short-term impact of settlement and consolidation may be worth it. And even after bankruptcy, it is possible to rebuild credit and achieve a debt free lifestyle. Always do your research first and carefully assess your unique situation. There’s no single answer for everyone!
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