Your credit scores play an important role in your overall financial health. Without good scores you will pay higher rates whenever you borrow money, which is most significant with a larger loan such as a mortgage. In fact, living with lower credit scores will cost you thousands of wasted dollars per year and even tens or hundreds of thousands of wasted dollars over the course of your lifetime.
Adding a collection account to your credit reports makes it harder for you to borrow money in the future and, by extension, puts pressure on you to pay the outstanding debt.
Step one is learning how to earn and maintain great scores. If you are new to the credit game you may have already made some damaging mistakes, such as allowing debt to go into default or to “collections.” And when an account goes to collections, a record of the default will almost always end up on one, two or all three of your credit reports. Here’s how it works …
Collection Accounts and Your Credit Reports: The Chronology of Events
When you fail to pay a financial obligation, the creditor will eventually throw up its hands and conclude that you’re not going to pay the debt back. At that point, the creditor may sell or consign the debt to a collection agency. Collection agencies, also known as third-party debt collectors, specialize in attempting to collect outstanding balances from you.
One of the ways a collection agency may try to compel you to pay your defaulted debts is by reporting the collection account to the credit reporting agencies. Adding a collection account to your credit reports makes it harder for you to borrow money in the future and, by extension, puts pressure on you to pay the outstanding debt. This is all 100 percent legal as long as you actually owe the debt.
Credit Score Impact
Collection accounts are not good for your credit scores, but they’re not always bad for your credit scores either, especially if your credit reports are already polluted with negative information. If your credit reports show derogatory history, such as collection accounts, a credit scoring model would likely determine that the risk of you continuing to miss payments is very high and, as a result, would award you with poor credit scores. Roughly one-third of the points in your FICO and VantageScore credit scores are based on the presence or lack of negative information.
Will Settling or Paying Collections Help?
The bad news is that it is not always quick or easy to undo the credit score damage caused by collection accounts. The reasons are two-fold.
- The Fair Credit Reporting Act (FCRA) allows most collection accounts to remain on a credit reports for seven years from the date of default on the original account. The seven-year statute of limitations does not change when the balance on the account is paid. It’s still seven years. As long as paid collection accounts remain on your credit reports, they can continue to be considered by credit scoring models.
- The credit scoring models currently used by most lenders were not designed to be forgiving whenever a collection account is paid or settled. Instead, it is the mere existence of the collection account on your reports that causes the credit score damage, not the balance. As hard as it is to believe or understanding, a collection for $10,000 is just as bad as a collection for $500 or a collection that has been paid or settled and now has a zero balance. The reason is because you have proven that you will allow a debt, regardless of the dollar amount, to go unpaid long enough for it to end up in default. That’s predictive of elevated credit risk, which is why even paid collections don’t result in a higher credit score as long as they’re still on your credit reports.