Improving your credit vs paying down debt

By Felix Salmon
October 12, 2009
Mitra Kalita profiles Karen King, who has debts of $36,000 and a credit score of 576. King wants to get the former down and the latter up, but sometimes those two impulses work against each other:

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Mitra Kalita profiles Karen King, who has debts of $36,000 and a credit score of 576. King wants to get the former down and the latter up, but sometimes those two impulses work against each other:

With the aid of a financial counselor provided by a nonprofit, Ms. King is applying triage to her debts. “First, I want to take care of all the little things,” she says, “and then the student loans.”

When a utility to which she owed $300 offered to settle for less, Ms. King says, she declined, because she was told an overdue bill takes longer to come off a person’s credit report when it is settled for a partial payment.

This is what happens when people obsess about credit score at the expense of their broad financial health: it’s much the same thing that happens when people try to lose weight instead of simply trying to get healthier.

In an ideal world, people would simply find their credit score increasing as their financial well-being improved. But in the real world, there’s a whole cottage industry which has sprung up devoted to trying to maximize credit scores, as well as ancillary industries such as Ben Stein’s evil attempt to trick people into paying $30 a month for a service they neither need nor can afford.

What worries me is that the financial counselor provided by a nonprofit might well have been the person advising Ms King not to pay off her utility bill at a discount. Often these financial counselors are seconded from some arm of the financial-services industry, which has an institutional interest in people paying as much of their debts and penalties as possible. Meanwhile, of course, from an individual perspective, if you can pay off a debt at a discount, most of the time it makes perfect sense to do so.

Annoyingly, Kalita never tells us whether it’s generally true that paying off an overdue bill at a discount is likely to be bad for your credit. If it’s not true, of course, then King was extremely badly advised. But even if it is true, there’s a strong case that she should have taken the offer anyway.

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Comments
13 comments so far

My sister tells me her husband’s probationary year as a federal prison guard requires he show “financial stability” — ie, clean up his credit report. He even took a loan out to pay off the cell phone company. If jobs keep coming to depend on your credit score, anything you can do to protect it will be worth it.

Not that I mind — it seems like a good incentive for people to pay what they owe.

Posted by Noumenon | Report as abusive

“…there’s a strong case that she should have taken the offer anyway.”
not at all, you are ignoring the consequences of a bad credit rating like diminished job prospects…

I’m not seeing anything in the above about the tax implications (a bill) for the ‘forgiven’ debt. It’s possible (even likely given by definition she doesn’t have a lot of cash for settling minor complications like pacifying the IRS) that she would be best advised not to take the settlement depending on her tax affairs. Partial facts make it hard to know. (I’m not a tax advisor but suspect the utility company would report the forgiven amount to the IRS and send her the relevant form for tax time, credit card firms do AFAIK). Maybe she made the right decision for the wrong reasons but this is why it’s so hard to discuss these stories in the media as so many articles report only the partial story (really who is going to be hooked by the juicy story of someone’s tax bill vs their electricity bill, it’s not sensational enough and the journalists often don’t seem know which questions to ask to get the salient facts even if they want to and don’t have some other objective)

Posted by SP | Report as abusive

the consequences of a bad credit rating like diminished job prospects

Why is this still legal? Is there any legitimate reason whatsoever to allow class discrimination in hiring?

Posted by chris | Report as abusive

@chris: Of course it’s legal – debtors are not a protected class. Did you think they were?

Posted by Curmudgeon | Report as abusive

As one with a good credit score, I have this to say — if you can get a discount on ANY debt, grab it while you can. I would gladly take it. No possible harm can come from it. And SP’s comment about possible tax implications make no sense, at least not in the USA. It’s not as though this reduction will count as undeclared income. That would be akin to saying that the IRS will come after you for renegotiating your mortgage and reducing your monthly payments. They don’t care about that sort of thing. Take a look at the IRS tax form for individuals, there is not even a check-off box for that.

The truth is that by paying off the bill it will reduce your indebtedness-to-income ratio by that amount. And that’s what really matters (as I saw on my own credit report this past Spring when I refinanced my mortgage). The less debt you have, the better, though it is a good idea to occasionally take out a smallish loan just to show that you have the ability to pay it off

As for Ben Stein, he’s a slippery poseur. I suspect the intelligence of anyone who attacks evolutionary theory as stridently as he does. It calls into question his competence on any number of issues, especially when it comes to handling my money.

Posted by Bob Foster | Report as abusive

All credit rating agencies, Wall Street and Main Street, are a total SCAM, FICO being the worst. — Don’t forget to obtain a free credit report at annualcreditreport.com. Print out the form and mail it in, do not try online, they want a fee. Also make sure you are not duped by similar-named web sites.

Posted by Bill | Report as abusive

I have a neighbor that lost her job because of her personal finances. I have seen her water turned off for non-payment, her gas turned off for non-payment and a car taken out of commission because she could not afford the $37 license tags. She says she will never be able to get a job again in her field and that is the only thing she knows how to do. She was a bank manager. Is it any wonder we are in trouble.

Posted by peanut1000 | Report as abusive

Bob Foster, this is just false. The IRS treats forgiven debts as income, and they will indeed come after you for it–Congress has temporarily abated this for mortgages, but ordinarily, if you get a portion of your loan forgiven, that’s taxable income. And they do care. It may take them a couple of years to get to you–but your bank will report the forgiveness, and you will be hit with a tax bill and penalties.

If you sell your house at a shortsale, say you owe $200,000 and the bank approves a sale at $120,000, then you owe the IRS taxes on that $80,000 that the bank lost as it was income to you even though you did not get it. The bank claimed that $80,000 as a loss and someone must pay the tax on it since the government will no longer be able to get the money from the bank. If you took the $4500 cash for clunkers you owe a tax on that, if you take-I believe- the $8,000 credit for first time home buyers you will owe a tax on that. That is just the way it is in Barrack Hussein Obama world.

Posted by peanut1000 | Report as abusive

Bob Foster above – try http://www.irs.gov :

“Topic 431 – Canceled Debt – Is it Taxable or Not?

In general, if a debt for which you are personally liable is canceled or forgiven, other than as a gift or bequest, you may have to include the canceled amount in gross income. Depending on the circumstances by which your debt was canceled and the nature of any property associated with the debt, the canceled debt may qualify for an exception to resulting in gross income, or the canceled debt may result in gross income but the income may be excluded.

A debt includes any indebtedness for which you are liable or which attaches to property you hold. [.....]Regardless of the factors relating to the cancellation, you must report any taxable amount as ordinary income from the cancellation of debt on Form 1040 or Form 1040NR and associated sub-schedules as advised in IRS Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments. ”

and google ‘cancelled debt’ or forgiven debt’, there has been a lot about this on the internet. So if eg ‘Evil Credit Card Co’ 30,000 and they offer to settle for 5,000 they will report the 28,000 to the IRS and usually issue a 1099 (in fact if you don’t get a 1099 afaik you’re still obliged to report it. Check out the dreaded 1099-C (http://www.irs.gov/pub/irs-pdf/f1099c.p df) Yes, people get surprised by this. Do you think all the debt ‘counselling’ services manage to remember to mention this to all clients?? It’s one of the reasons a person needs to be super careful in picking any agency to work with who promises to reduce debts to pennies on the dollar.

“That would be akin to saying that the IRS will come after you for renegotiating your mortgage and reducing your monthly payments. They don’t care about that sort of thing.”

No it isn’t akin to that. Recasting or reamortizing a mortgage while the principle stays the same is not the same as saying ‘you owe me 30,000 and I’ll settle for 5,000 and cancel the rest’. The key words are settle, forgive, cancel. Regarding mortgagedebt forgiveness, check out the 2007 bill http://www.irs.gov/newsroom/article/0,,i d=174034,00.html (which link by the way includes the phrase ‘you borrow $10,000 and default on the loan after paying back $2,000. If the lender is unable to collect the remaining debt from you, there is a cancellation of debt of $8,000, which generally is taxable income to you.’

I am not a financial advisor and I don’t play one on the internet.

Posted by SP | Report as abusive

The Wall Street article implies responsibility for the creation of a credit/debt society lies with government policy and legislation. Not quite. It lies with a population overwhelmingly brainwashed by the financial industry mass media campaigns that it is OK to be financially stupid and irresponsible.

Karen King reckoning and steep adjustments are well-deserved. But she errs again in what lesson to learn. She wants to improve her credit score. Thus confirming that her brain is still quite washed. Rather, her goal should be to improve her equity score. Last time I checked, Americans are still obsessed with FIDO – such is the nature of a dumbed down society. I am not aware there is a ‘score’ for having great equity.

Ah yes, many ex-Wall Street bankers have fantastic equity scores. But they make darn sure society never get around to it.

Posted by The Real Deal | Report as abusive

Having a lower debt to income percentage does indeed help you qualify for new credit products and will raise your credit score over the long term as compared to having balances still owed and unresolved. My statement about the act of settling a debt “does not in and of itself” raise your score in the above article remains true.

I cover the issue combined with debt settlement and access to new credit products fairly thoroughly in an article on the Consumer Recovery Network site. The article compares credit score impacts with debt settlement, bankruptcy and debt counseling services.

Posted by eugenecilliers | Report as abusive
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