The credit world is full of myths and misconceptions: Credit scores are used by employers. You only have one credit score. Closing credit card accounts can help your scores.
All of these are demonstrably false, yet they seem to have a life of their own in the blogosphere.
Another myth that has sprouted up recently has to do with charge-offs and collections. The myth is that they’re the same thing. This post will serve to dispel that myth. Although both charge-offs and collection accounts can potentially cause credit score damage, they’re not actually the same.
Charge-Off vs. Collection
When you fail to pay a debt for a long enough period of time, it will eventually go into default. Your lender may eventually give up on you paying the debt. And, as an accounting maneuver, they may move the debt from being a profitable asset to a business loss on their accounting ledgers.
That move is formally referred to as “writing off to profit and loss.” Informally, we call that a “charge-off.” Charge-offs are commonly reported to the credit bureaus.
Conversely, debts that have gone into default are also sometimes either sold or consigned to third-party debt collectors, or collection agencies. These accounts are known as “collections.” Collections are also commonly reported to the credit bureaus.
How Do Collections and Charge-Offs Impact Your Credit Score?
Both charge-offs and collections have the ability to damage your credit scores. The reason both of these issues can damage your credit scores is that both collections and charge-offs are predictive of elevated credit risk. As your risk goes up, your credit scores come down.
Although both charge-offs and collections are considered derogatory entries with the potential to harm your credit scores, there are other factors that will determine how much your credit scores are impacted, if they’re impacted at all. The first consideration is the recency of the incident.
Let’s assume your credit report is perfectly clean with the exception of one collection and one charge-off. In this case, you might be able to determine which entry is having the more damaging credit score impact by looking at which one occurred more recently. For example, if there’s a collection account on your credit report that is three years old, and a charge-off that is three months old, the newer charge-off is damaging your credit scores more.
Accounts that have been charged off by a lender will often be reported with a past-due balance to the credit bureaus. A past-due balance is another credit report entry considered by credit scoring models — and, as you can imagine, past-due balances are not good for your scores. A charged-off account that has a past-due balance is worse than a charged-off account that has been paid or settled.
Meanwhile, the balance associated with a collection account is not considered in FICO’s scoring models. I know that’s hard to believe, but the value of a collection in your score is the incident, not the balance. That’s why paying off a collection doesn’t actually result in a higher credit score.
And you could even get hit with a double-whammy, where a charged-off account leads to a collection, and both end up being reported to the credit bureaus. Here’s how: You have an account that goes into default and is eventually charged off by the bank. That is reported to the credit bureaus. Then, the bank outsources the debt to a third-party collection agency, who also reports it to the credit bureaus.
As long as the collection is the only entry that shows a balance, that’s perfectly legal and standard. But it’s yet another reason why it’s so much better to avoid charge-offs in the first place.
More by John Ulzheimer:
- Which Debts Should I Pay Off First to Raise My Credit Score?
- Four Ways You Could Be Harming Your Credit Score Without Realizing It
- This Is the Law That Protects You From Abusive Debt Collectors
John Ulzheimer is an expert on credit reporting, credit scoring, and identity theft. The author of four books on the subject, Ulzheimer has been featured thousands of times over the past decade in media outlets including the Wall Street Journal, NBC Nightly News, The Los Angeles Times, CNBC, and countless others. With professional experience at both Equifax and FICO, Ulzheimer is the only credit expert who actually comes from the credit industry. He has been an expert witness in over 230 credit related lawsuits and has been qualified to testify in both federal and state courts on the topic of consumer credit.