How Debt Affects Our Credit Rating | by Guest Author Linda Stern, Licensed Insolvency Trustee
At some point or another, we all slip up with paying our bills on time. Holiday plans can throw us off schedule. A busy season at work or a newborn in the family can cause distraction, leading us to forget when bills are due. Even though we shrug off these lapses as minor, our creditors take them seriously. They rightfully hold us to account with consequences, often in the form of an interest charge on the next bill. However, a lot more goes on behind the scenes when you forget to pay bills.
Creditors track this behaviour with a credit rating and report the misdemeanors to credit bureaus like Equifax or TransUnion. An R1 credit rating is the best, denoting on-time payments. Late payments are reported as an R2, if the bill is 30 days late, and an R3 if it is delayed by 60 days. The Credit Bureaus use this information to compute our overall credit score which informs others how credit worthy we are.
The process remains fluid. As we clear our debts and maintain good bill payment habits, the poor ratings get buried and our credit scores improve. However, they take a serious beating when we neglect our bills and let them go into collection or worse. At the bottom of the scale is an R9, which indicates a bankruptcy.
Debts in Collection
All lenders have different thresholds for when they write off chronic debt. They sell these at a loss to third-party collection agencies. Credit card companies generally do so at the 180 day mark. And with this, you become exposed to aggressive demand letters, collection calls and even wage garnishments from collection agencies. In addition, either the creditor or the collection agency will report this delinquency to credit bureaus who will mark your account with a “collection” status of R6. Your credit scores will drop significantly without any warning or notice.
If you hit a rough patch with your finances, the least you can do is pay the minimum amount on your credit card by the due date and suffer the interest rate penalties. You must completely avoid the non-payment triggers that risk the debt going into collection. However, be very diligent to use this as a short-term band aid for a few months at the most. If you expect your financial shortfall to last longer, then seek debt counselling urgently. Credit card interest rates are the highest in the debt industry. They will drive you deep into debt, faster than any other kind of credit.
The severity of the credit rating penalty depends on the amount and type of debt. Some bureaus show leniency to debt caused by medical bills, for example. Regardless, an R6 debt in collection spells trouble. It flags you as a credit risk and gives companies enough reason to deny you credit. And when this happens, life can become difficult and significantly inconvenient. Landlords may turn down rent applications; telecom providers could deny you affordable monthly plans, forcing you into more expensive prepaid services. Utilities may deny you services altogether without upfront deposits, etc.
Legal Actions & Your Credit Rating
Similarly, you should never ignore legal actions like a non-payment Plaintiff’s Claim originating from Small Claims Court, for example. If you owe money, even if you have a valid reason for not paying it, responding with a defense allows you to present your side of the story at a pretrial settlement hearing. The matter will only escalate to a trial if you do not arrive at a negotiated settlement. However, ignoring the Plaintiff’s Claim can be detrimental and result in a default judgement against you. And this becomes just like a debt in collection.
Also, once the matter is settled in court, you must honour your repayment obligations. Failure to do so will permit the plaintiff to apply for wage garnishments and even freeze your bank accounts to recover their funds. And they will report this delinquency to the credit bureaus, resulting in a hit on your credit score.
Debt Management Plans
A Debt Management Plan (DMP), is a viable solution for consolidating and repaying chronic, long-term debt. You engage the services of a credit counsellor to negotiate debt repayment terms with your creditors to pay them back within 5 years. To give you a leg up, creditors offer concessions, like removing or reducing the interest rate penalties. The point of a DMP is to make the repayment terms as manageable as possible for your circumstances. The counsellor also assists you with budgeting and arms you with financial literacy, so you learn how to steer clear from future debt problems.
Once registered in a DMP your credit score will take a hit, to an R6, just like debts in collection. You may cringe about this and even avoid a DMP because of it. However, don’t forget the big picture. At this stage, your credit scores have already suffered. The DMP will make it worse for a short period only. However, it offers you much needed relief from compounding interest rate penalties and will stop harassing collection calls and wage garnishments. In the long run, the DMP gives you peace of mind while allowing you to repay your debt and repair your credit.
A Consumer Proposal or Bankruptcy
If your debts cannot be repaid through an asset sale, a bank loan, home refinancing or a DMP, then the Bankruptcy and Insolvency Act allows you two ways to legally walk away from them: A Consumer Proposal or a Bankruptcy. To proceed with either option you require the services of a Licensed Insolvency Trustee (LIT) who will review your assets and finances and advise you of your options. Your LIT will also negotiate with your creditors and administer the financial transactions.
Creditors take consumer proposals and bankruptcies seriously. They stand to recover a fraction of the original debt under these circumstances. Consequently, they will penalize you with the lowest credit ratings, R7 to R9.
For a Consumer Proposal, an R9 will remain on your record for the term of the proposal. Faster repayments offer you opportunities to clear this up quicker. Once settled however, this improves to an R7 for three years after the settlement date. To creditors, this indicates that while you are still a credit risk, you took your responsibility seriously and met the terms of your Consumer Proposal.
If you file a bankruptcy for the first time, an R9 remains on your file for 6 years after the discharge date. If you unfortunately suffer a second bankruptcy, then creditors are less forgiving. The rating will remain on your record for 14 years after discharge.
Credit is vital to our system of commerce. While this credit rating system punishes some, it also rewards people with good payment habits. They enjoy favourable rates and terms on loans, like mortgages, for example.
Also, this credit rating system is not static or permanent. It allows you to learn and recover from your mistakes. Even after you suffer a dent on your credit score because of a DMP, Consumer Proposal or Bankruptcy, the system affords you opportunity for remedial action. A credit counsellor or Licensed Insolvency Trustee are trained professionals who help you do just that. You can definitely rebuild your credit and earn back your credit worthiness.
Linda Stern, a Licensed Insolvency Trustee, is a guest blogger for Family and Credit Counselling Services, a blended not-for profit community-based agency offering debt counselling & management as well as family/individual support services within York region.
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