How Are Credit Scores Determined?
Your credit score is an indicator of your creditworthiness, and helps banks and other creditors evaluate whether it is safe to lend you money. Whenever a person opens, closes, makes payments, defaults, or takes any other actions on a credit product such as a loan or credit card, this is reported to credit bureaus Experian, Equifax, and TransUnion. A person’s credit history goes into calculating their credit score.
According to FICO, the company that devised the credit score formula, credit scores are formulated from the following 5 elements:
Payment history (35% weighting): Penalizes borrower if they have failed to pay back past credit accounts on time.
Amounts owed (30%): Penalizes borrower if they are over-extended on credit.
Length of credit history (15%): The longer the borrower’s credit history, the better.
Types of credit used (10%:) Considers the borrower’s mix of credit cards, instalment loans, finance company accounts, and mortgage loans.
New credit: Penalizes borrower if they open too many credit accounts in a short period of time, especially if the borrower doesn’t have a long credit history.
Types of Debt Relief and Impact on Credit Score
1. Debt consolidation
- What is it? Consolidating multiple debts into one loan
- Impact on credit score: Can have small negative impact in short-term. Positive longer-term impact if new loan is paid off in time.
2. Debt management
- What is it? Negotiating new payment terms with creditors
- Impact on credit score: Negative impact in short-term. Potentially positive impact in long-term.
3. Debt settlement
- What is it? Negotiating partial repayment with creditors
- Impact on credit score: Negative impact, remains on credit report for 7 years.
- What is it? Involves restructuring or elimination of debts
- Impact on credit score: Negative impact, remains on credit report for 10 years.
When Can Debt Relief Help Your Credit Score?
The only type of debt relief that can help a person’s credit score is debt consolidation. Debt consolidation involves consolidating multiple debts into one loan with one monthly payment. The benefit of debt consolidation is that you pay off your debts with a lower interest rate and lower monthly payments. All types of consumer debt can be consolidated, including credit cards, student loans, and medical bills.
Debt consolidation can have a negative impact on credit score in the short term, because it is marked as failure to pay old credit accounts. In the long term, paying off the new consolidated loan on time can actually improve your credit score. Not everyone is eligible to consolidate debt; it depends on things like the person’s current credit score, the number of existing credit cards they have in their possession, and their level of debt. For those who qualify, debt consolidation is the best type of debt relief because it won’t cause long-term damage to your credit score.
When Can Debt Relief Hurt Your Credit Score?
The other types of debt relief all have a negative impact on credit score, although debt management leaves the door open for an improved credit score in the long term. Bankruptcy and debt settlement cause long-term damage to your credit score and should only be used as last resorts.
There are 2 main types of bankruptcy to be aware of. Chapter 7 is for people with few or no assets and allows them to dispose of unsecured debts such as credit cards. Chapter 13 is for people who have too much money or too many assets to qualify for Chapter 7. Bankruptcy can remain on a person’s credit report for up to 10 years, making it difficult to borrow or refinance.
Debt settlement refers to a situation in which a creditor agrees to accept less than the full amount owed by a debtor or debtors. It is usually only an option if the debt is unsecured, because the creditor can’t seize any assets and may therefore be open to partial repayment. Debt settlement can be applied to any type of unsecured debt, including personal loans, student loans, or credit card debt. Debt settlement is considered failure to repay a credit account on time, and has a negative impact on credit score. A debt settlement stays on a person’s credit report for up to 7 years.
Debt management involves negotiating new interest rates or terms with your creditors. Through negotiation, your creditor might agree to reduce your interest rate or extend the life of the loan. In both cases, the result is lower monthly payments, making it easier to pay off the debt. Debt management usually requires forced closure of credit accounts, which damages your credit score. If the debt management plan involves less than full repayment, this also damages your credit score. In the long term, paying off the loan under the new terms can help rebuild your credit score.
Before Opting for Debt Relief, Always Think About Your Credit Score
As this article shows, the different types of debt relief can have vastly different impact on a person’s credit score. All types of debt relief can cause negative damage, but debt consolidation can actually improve your credit score in the long run if you pay off your new loan on time.
Bankruptcy and debt settlement are disastrous from a credit score perspective and should only be considered as last resorts. In the worst case, having these things on your record can make it impossible to qualify for credit cards, auto loans, and mortgages. In the best case, it can make it harder to qualify for a good interest rate. The higher the interest rate on a credit product, the more you have to pay each month, the harder it is to pay off, and the harder it is to get out of the spiral of debt. Therefore, think carefully about the potential impact to your credit score before agreeing to debt relief.