Wednesday, September 7, 2011

How Much Do Collections Hurt Your Credit Score?

You know that collections on your credit report hurt your credit score, but how much? Probably less than you think.

How Much Collections Hurt Your Credit Score?
Collection accounts are derogatory entries on your credit report, but a collection account isn't like a bankruptcy or foreclosure, which are the financial equivalent of Monopoly's "Go directly to jail, do not pass Go, do not collect $200" card.

Here's why: Your credit's already damaged. 

When a lender charges off your delinquent debt and sells the account to a collection agency, the payments you missed and the lender's charge-off damage your credit rating. A damaged credit rating is less vulnerable to negative entries that a positive credit rating.

No one knows the exact scoring formula, but what we do know is that a negative entry hurts someone with good credit far more than someone with bad credit. Look at these two hypothetical scenarios:

Joe has a credit score of 750. Or, at least, he thinks he does. When Joe goes to apply for an auto loan, expecting to get an excellent interest rate, he's quoted a rate far higher than he thinks he deserves. After going home and pulling his credit report and FICO scores, Joe is shocked to learn that a collection agency has hit his credit report for a debt he wasn't even aware of – costing his credit score 120 points. 

Jane has had numerous debt problems in the past and can't keep up with her credit card payments. She finally defaults on the balance she owes – knowing that it will end up in collections. Jane's credit score is 550 when the credit card company finally charges off the debt. Four months later a new collection appears on her credit report, but Jane isn't too worried. The new collection only costs her 30 points – bringing her credit score down to 520. 

In Joe's case, his good credit rating caused his credit score to go into free fall from a single collection hitting his credit report while a collection hitting Jane's credit didn't have that much of an impact. The degree to which a collection hurts your credit score – and how many points you can expect to lose – is directly related to how high your credit score is when the collection agency reports the debt. The higher your are, the greater the fall. 

Estimating the Damage Collections Do to Your Credit Rating
As much as you'd like to know ahead of time how much damage a collection account will do to your credit rating, estimating the damage is just that: an estimate. Each piece of information on your credit report affects your score to a different degree. Thus, two people with the same credit score may have drastically different results should the same collection account for the same amount hit their reports. On average, with an average credit rating, an individual may suffer anywhere from 50 to 75 points of damage, but that's just a ballpark figure. As I stated before, everyone is different.

Collection Amount Affects Credit Score Damage
One thing most debtors don't realize is that the amount they owe a collection agency influences whether or not their credit scores take a nose dive once the entry hits their credit files.

Since time out of mind Fair Isaac's credit scoring model counted all collections pretty much the same way. The scoring formula didn't differentiate between a $20 collection for an unpaid library fine and a $5000 collection for a unpaid student loan. One person is clearly the greater credit risk than the other, but the system didn't reflect that.

With the release of FICO '08 in early 2009, the scoring formula now has a way of differentiating between consumers who have clear debt management problems and those who got nickel and dimed all the way to collections. If the original debt you owed was less than $100, the resulting collection account may show up on your credit report but it won't hurt your credit score.

Related Posts:

Collections on Your Credit Report

Collection Accounts and Your FICO Score

Credit Reporting Period vs. Statute of Limitations

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