How Charge-offs Work, How They Affect Your Credit

Dear New Frugal You,

I often hear the phrase "charge-off" used in discussions about credit cards and credit scores. I don't understand what it is. Could you help explain it and how it affects me? 

-Confused in Carolina

Dear Confused,

You're exactly right! You are hearing much more about charge-offs lately. And, the term can be a bit confusing if you're not familiar with accounting or financial jargon. Let's see if we can't shed some light on the subject.

There's a reason charge-offs are in the news. According to the Federal Reserve, banks reported that in the second quarter of 2011, a bit less than 2% of all loans and leases have been charged off, as has a bit less than 6% of all credit card debt. While those levels are down sharply from 2009 and 2010, they're still much higher than they were before the recession.

Let's discover what a charge-off is and is not. A charge-off is an accounting entry. A bank or other lender considers your debt to be an asset. It's an asset because it has value. But if you get behind in your payments, the value of that asset falls into question. And, after a while, the IRS requires the bank to remove your loan from its assets. The bank then "charges off" part or all of your loan from its books.

So a charge-off is an accounting activity. It also is a report that goes to the credit bureaus and gets incorporated into your credit score. If you have a loan marked as charged off, it will hurt your credit score. A charge-off will remain on your credit report for seven years.

What it is not is a release from your debt. Even if an account is charged off, you still owe the money. And, as it turns out, it may even make it more difficult to repay the debt afterward.

Charge-off aftermathHere's why. When a bank charges off a debt, it will typically do one of three things:

*Try to collect the debt itself.

*Hire a collection agency to collect for them.

*Sell the debt to a collection agency.

You have no control over when a debt is charged off. That's determined by law and the lender. Even if you have every intention of repaying the loan, it may still be charged off. A credit card account is usually charged off when the customer fails to make minimum payments for 6 months.

As we mentioned, this action will hurt your credit score. 35% of your score is based on your payment history. Any late payments will lower your score. So the charge-off hurts, but most of the damage has already been done by the late payments. The higher your score was to start with, the greater the damage will be.

Debts still worth paying

Once a debt is charged off, it will be tempting to not to pay it even if you have the money to do so. You may want to reconsider for two reasons.

First, by paying the debt, you can change the status of the account to "charged off, paid." That tells other future lenders that you make every effort to repay, even if it's hard to do so. That status looks much better to lenders than a status of just "charged off."

Second, if you negotiate a debt settlement (paying less than you owe), you could find yourself owing taxes. Any time a lender forgives a debt of more than $600, it is required to notify the IRS and the forgiven debt is added to your taxable income for the year.

If that does happen, you may qualify for an exemption. The exemptions are fairly generous. See a qualified tax preparer to be sure.

I hope you're not behind on any of your bills and the question about charge-offs is just because you're confused. Yet, even if that's the case you'll still be affected by charge-offs.

The credit card companies estimate how much they'll lose to charge-offs. And they charge everyone higher fees and interest rates to cover those losses. So everyone who uses a credit card will pay a little extra because of charge-offs.

For the next year or two, we'll all continue to hear more about charge-offs. It's an unfortunate side effect to a tough economy and the large amount of consumer debt outstanding.

See related: Repaying charged-off debt, Debt negotiation in three (not) easy stepsHow many points off? FICO reveals how common credit mistakes affect scores