What is a charge-off and how does it affect your credit?

Some of us may have missed or forgotten about a payment once or twice without doing irreparable damage to our credit. But there are times in people’s financial lives when things take a nosedive for any number of reasons and they come to a significant turning point. This is when things can get serious. It’s important for you to recognize when you’re in this position, how much damage you’re likely to incur to your credit and what comes next.

One of the most damaging credit score consequences of falling behind on payments is what’s known as a charge-off.

What is a charge-off?

A charge-off is an uncollected credit card balance that has been overdue so long it gets removed from a bank’s books and charged against its loss reserves. For the card issuer, this means it has decided that your debt is unlikely to be collected, so it “charges” the debt off its books.

It’s important to remember that debts that have been charged off are still debts that are owed, accruing interest and penalties and, most importantly, collectible.

How does a charge-off affect your credit score?

Having a debt charged off is the next most serious negative item on your credit report and score next to a bankruptcy. There are two types of charge-offs that may appear on your credit report: paid and unpaid.

As the second-most serious indicator of not paying your bills on time, the charge-off notation hits your credit score hard in the payment history and amounts owed categories.

Depending on how much positive data you’ve accumulated in your credit file over the years, you could be looking at a significant credit score drop. Paying your bills on time every single time means never having to worry about terms like charge-offs because that only happens if you don’t pay your bills.

This is not to say that you risk a charge-off if you are late or even miss a couple of payments. You could definitely risk damaging your score if you do that, but it generally takes longer for a charge-off to occur. This is most likely to happen when your account falls 180 days past due. That means you haven’t paid a bill for at least six months.

In reality, it’s sometimes more like seven or eight months because you generally aren’t reported delinquent until you’re at least 30 days past due. While forgetting a payment one month might be understandable, that logic won’t hold up over the long haul. When you get into the two- or three-month range, there is obviously a problem that you need to address.

What happens after an unpaid debt gets charged off?

After an unpaid debt gets charged off (if not before) your creditor will certainly reach out to you to find out what is going on and when they can expect a payment from you. If you don’t have an answer, you may be embarrassed and tempted to just ignore or dodge those inquiries. Things will only go from bad to worse if you do.

If your creditor finds you unresponsive, there is a good chance that your debt will be placed with or sold to a third-party collection agency. If you think calls from the original creditor are aggressive, you’ll likely find  professional debt collectors far less congenial.

Here’s why: Initially the creditor is trying to get in touch with you to help. They may have programs, reduced pay options and more to help a customer who they want to keep. When a collection agency buys a debt, you are essentially considered a liability that needs to be turned into a cash return.

Of course, there are protections against harassment from a creditor and third-party collector in the Fair Debt Collections Act. This includes excessive phone calls, false threats and abusive language.

You have the option to tell the collector you don’t want to be contacted again about this debt. They are bound by law to stop the calls and letters. However, what most will do then is to immediately send your file to their legal department for court action.

It’s important to understand that just because a debt is charged off, it does absolutely nothing to release you from your obligation to pay it. If you don’t pay, you could eventually be sued in court for the amount you owe. And if you choose to ignore a court summons, you will lose automatically.

At that point, you could face a judgment that might even garnish your wages depending on the state laws where you reside.

How long does a charge-off stay on your credit report?

You should also know that a charge-off remains on your credit report for seven years. This is true even if you eventually pay off the debt.

A credit report notation of “charge-off paid” will make your mistake look somewhat better to future lenders. It shows you had a problem, probably a serious one, but that you eventually honored your commitment.

What paying a charge-off won’t do is raise your score a lot. Time will help blunt the charge-off’s impact, but paying the bill doesn’t change the fact that you’re a risk for lending. No one wants to wait six months or more to get paid on a debt that was supposed to have been paid as agreed.

Bottom line

A charge-off is a direct result of not paying a bill, which can hurt your credit score and linger on your credit report for seven years. As with everything related to credit reporting, instituting good credit practices moving forward is the best thing you can do to mitigate the amount of damage done.