Credit Myths #2 - Paying off Collection and Charge-offs will improve your credit score
While it is your responsibility to pay off your past due debts this will almost never improve your credit score and in many cases can hurt your credit score. I thought it especially important to include this information in this book because this misunderstood piece of the overarching credit puzzle causes some of the greatest damage to our client’s credit. Like most of our clients you are probably under the impression that paying off derogatory debt will help your credit score. You may be operating under the assumption that you are doing something good by paying this off and therefore should be rewarded with a better credit score. This entire assumption is false.
To better understand this lets take the example of a debt that has gone so far past due that it has now been sent to a collection agency. First, it’s important to understand that your credit was damaged by this collection because of the fact that it became a collection in the first place. In other words you didn’t pay this for this debt as agreed and therefore your credit score is lowered in an effort to warn other creditors that you pose a higher risk to them. Going back and paying this debt later doesn’t erase the fact that you didn’t pay it as agreed in the first place. It also doesn’t make you somehow a better risk to lend to, for future creditors. In fact, statistically speaking, if you have defaulted in the past it’s likely you will default on something in the future. Therefore your credit score needs to stay low in order to warn future creditors of your previous defaults.
Ok so now we know why paying off a derogatory debt such as a collection or charge-off won’t improve your credit. But how the heck can it hurt your credit? Well this is a bit of a tricky issue but the basic explanation is as follows. Most derogatory debts will eventually turn into a collection/Charge-off. These debts are required to fall off your credit after 7 years from the date that the debt “defaulted”. The creditor has up to 180 days to report this debt from the last date of default and therefore you can expect to see this on your credit for up to 7 years and 180 days. This timeframe also regulates how much damage is done to your credit report over time. You see as the “timer” ticks down the days the damage to your credit score is decreased over time. Legally speaking this should not happen but we see this happen more often than not when the debt is paid. Essentially it’s a reporting error by the creditor. You pay off the debt and when they report it as paid they also reset the timer and damage your score. This is probably the most rampant and consistent reporting error we see on a day to day basis.