The question that I've heard most frequently over the years of working and consulting with consumers who are struggling to pay overwhelming debt 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 consumers in order to sell them on; credit counseling in order to preserve a credit score that cannot be used; how bankruptcy is the worst thing that could happen to you and your credit report; and how settling debts for less than the balance owed will kill your chances for new credit for 7 years.
I want to lay out some facts
Let's start with this fact: Risk aversion by lenders, in the extension of credit, has returned with a vengeance! This means those of us struggling with debt and carrying high balances, will frequently find that additional credit is unavailable to regardless of your credit score. The past few years of the economic downturn saw many have their existing credit lines cut down to current balances and unused accounts getting 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 that people make irrational decisions, negatively impacting themselves and their families, all in the name of the all mighty FICO. 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 options, I will lay out the legitimate options and outline the effects to your credit.
Debt Management Plan (DMP, sponsored by for profit or nonprofit consumer credit counseling companies):
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 DMP. 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).
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 discharge 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 subprime credit card issuers having left the market, I did not see these solicitations for credit just outside of bankruptcy being offered much. At the time I first published an article on this topic, I suggested it would be less likely to see credit card offers directly after chapter 7 bankruptcy moving forward, as banks would be repairing their balance sheets for years to come. I am now seeing evidence that banks are stepping back in to attracting post bankruptcy consumers by offering lower limit higher interest credit cards.
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, given 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 months after discharge. Your credit score is factored on several data points. Roughly a third of it is factored on credit 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. 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 âNOâ. 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 if the purpose for filing is strictly based on overwhelming credit card debt.
Settling debts for less than the balance requires you to be behind in payments. Since about a third of your credit score is factored on repayment history, your credit report and credit 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 etcâ¦ 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 worked with individuals who have qualified 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.
These 3 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 ability to obtain new credit products. 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.
Chapter 7 bankruptcy and shorter duration debt settlement strategies actually track pretty well with each other 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.
Credit counseling programs may not provide the earliest opportunities to obtain new credit card accounts, but this option can track well with settling accounts and access to fairly priced home, auto and student loans.
The point of this article is - when you are drowning in debt and 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 motivated by some special interest.
When determining which debt relief option will best suit your 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 credit counseling and a debt management plan (DMP) beside a debt settlement approach, and make a rational decision based on the math and the flexibility that is built into either option. Settlement will win the flexibility test. When doing the math to qualify for a DMP, and when considering the current average, you will need to factor your ability to consistently and comfortably make a monthly payment of 2.1% of your current unsecured credit card balances. If you cannot, or question your ability to maintain this type of lower monthly payment, I question why you would even start a DMP. You have a high probability of not completing it 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.
Throughout the DebtCC website you will find many helpful details and feedback for reducing your debt using a DIY approach to settling with your creditors and DIY debt management plans. If you do not find what you are looking for, use the "ask expert" feature to post your questions and participate in the forum discussions. Throughout the site you will also find tools that can refer to respected experts offering professional debt relief services.
Get your unmanageable debt dealt with and your life back first. Credit can be repaired and your score will recover.