Credit Scoring and Why Paying Off Collections Doesn't Matter
The FICO scoring system--the most widely used by lenders in this country--exists solely to help lenders evaluate an applicant's level of risk. Can you imagine how much money banks and credit card companies would lose if there was no credit scoring system in place? Every single time they wrote a loan or extended credit to an individual they'd be playing financial Russian roulette. The FICO credit scoring system was born to help lenders maximize profits by lowering risk.
The logic works like this: You wouldn't have a collection on your credit report if you were financially reliable (mistakes happen, this is just the general rationale). A collection indicates that you're having money troubles or are unreliable in general. If either of those assumptions are true, that makes you a much higher risk to new lenders and creditors. In order to provide lenders with the most accurate risk-assessment possible, the FICO credit scoring system docks your credit scores accordingly.
Paying off collections doesn't improve your credit report because collections are always negative. Unlike a credit card or loan account which can be a positive credit entry if you pay your bills on time or a negative credit entry if you don't, a collection account can't swing either way. Once it hits your credit report it deals the maximum amount of damage it can, and paying it off doesn't help you. You could argue that the very act of paying off the collection debt demonstrates responsibility and that your credit scores should increase as a result (and I'd agree with you), but that simply isn't the way the system works.
Credit Scores Improve Over Time Whether You Pay Collections or Not
Fortunately, this dark cloud of debt collection has a silver lining. Collections don't hurt your credit forever. The FICO credit system takes the age of your credit report entries into account. The more recent an item is, the more relevant it is to your current creditworthiness. As time passes, both good and bad habits can change. This makes the most recent credit entries the most accurate. As such, they carry a greater weight during the scoring process.
This is good news for you if you're trying to rebuild your credit after a collection. Time is your friend. As long as you practice good debt management habits and keep your debt in check, your credit scores will gradually improve in time--whether you pay off the collection agency or whether you don't.
Credit Scores Improve After Collections Are Removed From Your Credit Report
Once the credit bureaus remove collections from your credit report, you'll generally see a marked increase your credit scores. The FCRA states that collections must be removed seven years from the date the original creditor's debt went delinquent. The delinquency date is usually considered to be the day your original debt went unpaid for 180 days. It doesn't matter how long the collection has been on your report. It's removal rests on the original debt's delinquency. The credit bureaus can remove collections, however, for any of the following reasons:
- The 7-year credit reporting period has expired
- The collection is the result of identity theft
- The consumer successfully disputes the debt's accuracy with the credit bureaus
- The collection agency removes the entry in exchange for payment
- The consumer sues the collection agency for reporting incorrect information and wins
How Collectors Use the Threat of Credit Damage to Make You Pay
If most consumers realized that paying off collections wouldn't improve their credit scores, many would opt to withhold those payments and put them to better use. Collection agencies are all too familiar with this fact. Because of this, collection letters often note that, if you pay the debt, "your credit report will be updated." This is misleading. The average consumer believes that this means paying the debt will improve his credit rating. In reality, all the collection agency does is update the debt's status to "paid" or "settled." This doesn't improve your credit scores.
Debt collectors also use this angle on the telephone. It isn't uncommon for a debt collector to try to convince a debtor to pay up by using a "but what about your credit?" argument. If the collection agency has already reported the debt to the credit bureaus, the damage is done. The "but what about your credit?" angle deceives the debtor into thinking that paying off the collection will lessen or even undo credit damage that has already occured. This, of course, is untrue.
When Paying Off Collections is a Good Idea
Although paying collections doesn't improve your credit score, your credit report will reflect the fact that you paid the debt. While some lenders see collections as negative no matter what, others will see the fact that you paid the collection as positive evidence that you're making an effort to keep up with your debts and be more financially responsible. Certain mortgage lenders will even require you to pay off collections before approving your mortgage loan. Paying off collection debts also prevents a whole host of negative consequences such as:
- Debt collection lawsuits
- Bank account garnishment
- Wage garnishment
- Civil Judgments
- Property liens
- Asset seizure
This doesn't happen to everyone. Unless the collection agency is working to collect debt on behalf of the government, the agency must sue you and win a judgment before it has the right to utilize more extreme collection methods.
In the long run, its up to you how to manage your debts in the way you see fit. If that means ignoring collections in order to put food on the table or working overtime to pay your debts in an effort to alleviate your moral compass, so be it. Just remember that whether or not you choose t pay off collections, doing so doesn't improve your credit score.
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