What does it mean if your debt is charged off as bad debt?

If your credit card or loan payments are delinquent for several months, you might have noticed a charge-off on your credit report. This occurs when the creditor has given up on collecting the money owed and has decided to categorize the debt as bad debt, meaning it is a loss for the company.

This does not mean you are off the hook for paying the remaining debt. In many cases, the debt is sent to a collection agency that will try to recover the balance owed. Here’s what you need to know about charge-offs, including what your liability might be and how it impacts your credit.

What is a charge-off?

When a creditor believes a debt will not be repaid, it is removed from the creditor’s balance sheet. Since the debt cannot be carried on the creditor’s books as an asset, the creditor will mark the debt as “charged off” and report that status to the three major credit bureaus.

“A creditor would do a charge-off so that the past-due amount can be written off as bad debt for tax purposes,” says Freddie Huynh, former vice president of data optimization at Freedom Financial Network.

The creditor lists the debt as an expense in its profit-and-loss statement, which reduces the company’s overall tax liability. Depending on the size of the company, taxes are not the only consideration for a creditor when charging off a debt.

“Creditors have to do this so that stockholders and others don’t get misled about the quality of loans outstanding,” says Mike Sullivan, a personal finance consultant for the non-profit Take Charge America. “Regulators demand transparency.”

How does a charge-off work?

A charge-off generally occurs when a payment is between 90 and 180 days past due. If no payment is made by this time, the creditor assumes the debt is unlikely to be paid in the near future. It will be listed as a negative mark on your credit report for seven years, although you may be able to negotiate with your creditor to have it removed early.

Categorizing a debt as a charge-off is an accounting term and in no way erases the debt that you owe. The lender is still entitled to the full amount owed until the statute of limitations expires, which is state-specific, and can pursue the debt in full.

Laws vary by state and depend on the type of debt that’s charged off. Be aware that some collectors may still attempt to collect by phone and mail, even if they don’t have the option of suing in court.

What to do if you have a charge-off

By law, creditors and debt collectors are required to provide the unpaid debt’s details in writing. This written correspondence is called a validation notice or debt validation letter and is required within five days of contacting you. The letter or notice should include the amount you allegedly owe, the name of the original creditor and instructions on how to contest the debt if it’s not yours.

Once you receive the validation notice, ask yourself the following.

Is the account yours?

Make sure that the charged-off debt is actually yours. If you have a common name or have a relative with the same name, a mix-up regarding who the debt belongs to might have occurred.

If you determine that the account being charged off is definitely not yours, it is important to communicate immediately with the credit bureaus about your concern. The best way to do this is by sending a letter to the reporting credit bureaus contesting the erroneous account.

“By law, the credit bureau must remove the post and ask the creditor for documentation,” Sullivan says. “The consumer can contest the posting online, but having a record of a written objection is better.”

Once the credit reporting agency and the creditor receive the dispute, it has 30 days to prove or disprove it. If it was an error, the credit reports must be updated to reflect that fact — if they have not been corrected already.

Is the account actually paid?

If you know that the account belongs to you but don’t remember having an unpaid debt, consult your payment records. An accounting error may have happened on the creditor’s end, especially if the account is old.

In cases where the charge-off is incorrect because the account was paid off, you should communicate with the reporting credit bureau and contest the post to your account. In these types of cases, you should also contact the creditor in writing with verification of payment.

“A copy of a bank statement indicating payments, or copies of creditor statements showing payment should suffice,” Sullivan says. “In all cases of charge-offs being reported in error, the first remedy is the written challenge.”

If creditors and credit bureaus are not responsive, the best remedy is usually small claims court. It is fairly simple and inexpensive to take a creditor to court.

“Very often large creditors will not even appear in court, but small claims courts are a good place for consumers to present their evidence and get a fair hearing,” Sullivan says.

Is the debt past its statute of limitations?

Creditors and debt collection agencies are legally allowed to pursue the debt until the statute of limitations in your state expires. The laws vary by state and also depend on the type of debt that is charged off. If you believe the statute of limitations may have expired, there are a few steps you can take.

Ask the creditor for the last payment date noted on the account. Legally, they’re required to answer honestly if they know. If the debt is older than the statute of limitations, a debt collector can no longer sue you in court for repayment.

However, in many places, debt collectors can still try to collect on old debts beyond the expiration of the statute of limitations. The account will also still be reported on your credit report for seven years.

Ultimately, if the charge-off account does belong to you, you’re legally responsible for paying the debt. Some collectors agree to settle for a reduced amount, and you might decide to pay the settlement amount. It’s best to consult with a debt attorney about the options available to you at this point.

Tips to avoid charge-offs

As much as possible, it’s best to avoid having an account charge-off as bad debt.

• Work out a payment plan: Many creditors would rather work with you on a manageable payment plan than not receive payment on the debt at all. If you’re facing financial hardship, including if your debt-to-income ratio has changed significantly, contact your creditors as soon as possible before your next payment is due.
• Create a budget: Put together a monthly budget based on your recurring bills and personal goals. If you can, build up an emergency fund to cover at least six months’ expenses in the event of unexpected expenses or unemployment. Then, assess whether you can afford to borrow on credit.
• Consolidate debt: While it may not always be an option if you have bad credit, a debt consolidation loan can potentially reduce your monthly payment. However, you will need to be in good standing with your current creditors in order to qualify for these types of loans.

How charged-off debt affects your credit

Creditors often report charged-off accounts to the credit bureaus. A charge-off as bad debt reflects poorly on your past payment history. Considering that 35 percent of your FICO score is based on payment history, you can expect your credit score to be adversely affected.

Besides damaging your credit score, an unpaid charge-off can harm you when you want to make a major purchase using credit, rent an apartment or apply for a job. Businesses may be wary of someone with any long-term, unpaid credit accounts.

If you decide to pay the charged-off account, the derogatory mark still won’t drop off of your credit history. Instead, it might show up on your report as a paid charge-off. This might help your score slightly, depending on the scoring model used, but could still be a red flag for future creditors.

Charged-off accounts and other negative marks stay on your credit reports for seven years. So if you choose not to pay, you will have to wait that long for the charge-offs to stop affecting you.

Bottom line

A charge-off doesn’t absolve you of the debt you owe. You are still legally responsible for the unpaid debt, and it will take time for your credit score to fully bounce back from a charged-off account. However, addressing a charge-off as quickly as possible can help lessen the impact on your credit score in the future.

If you have debt that has yet to be paid off but you are struggling financially, consider the best debt relief companies to get your finances back on track.