When paying bills can hurt your credit

By Liz Pulliam Weston

Cynthia worked hard to improve her credit scores. She was careful to pay her bills, including an auto loan and a credit card, on time every month. Finally, in December 2004, she decided to pay off the one old debt on her credit reports.

Her scores promptly plunged by as much as 95 points.

"I spent over $1,200 in paying off hospital bills from six years ago, thinking this would help," she wrote in an e-mail. "Did this hurt me instead?"

Borrowers who try to pay off old delinquencies, charge-offs and collection accounts often learn the hard way: Sometimes, doing the right thing does the wrong thing to your credit.

Quirky credit scoring system

Thanks to the sometimes bizarre quirks of credit scoring, state statutes of limitations and the federal Fair Credit Reporting Act, consumers can't always assume that paying off old debts will improve their financial situation or make them a better risk in lenders' eyes. Add in the tactics of some unethical collection agencies, and you have a real quagmire.

The one bit of good news, though, is that what happened to Cynthia -- a score plunge because of a new payment on an old debt -- is much less likely to happen today. That's because the company that creates the leading credit score, the FICO, worked with credit bureaus to iron out that particular wrinkle in the formula.

But there are still other problems that can arise:

• Settling accounts for less than you owe can often hurt your credit scores.

• Arranging a payment plan or even inquiring about an old debt can restart the statute of limitations in some states, allowing creditors to sue you.

• Simply contacting a creditor about a past-due account can revive its interest in trying to collect, leading to harassment and hardball tactics.

• Unethical collection agencies may promise to upgrade how your debt appears on your credit report in exchange for payment -- then not follow through or make matters worse by making the debt seem more recent than it is.

To understand how these things happen, you need to understand some of the practices of the credit industry, such as:

How delinquencies and charge-offs are handled

A lender will generally write off an account as a bad debt within six months after it becomes delinquent -- in other words, six months after the borrower stops paying. The write-off is reported to the credit bureaus as a "charge-off."

Some people incorrectly believe that a charge-off means they no longer have to pay their debt. But "charge-off" is basically just an accounting term, notes debt expert Gerri Detweiler, author of "The Ultimate Credit Handbook." It doesn't relieve you of the legal or ethical obligation to pay the loan, and the lender or a collector can still come after you.

Usually, a lender will turn the charged-off account over to its collections department or a collection agency, and you'll have two entries for the same account on your credit report: one from the original creditor showing the account's status as "charged-off" and another from the collection agency showing the account's status as "in collections."

(If you have more than two entries for the same debt, which sometimes happens when an account is passed from one collection agency to another, you can demand the credit bureaus remove the extra entries.)

How your credit score views old debts

Not paying your bills is a big bad when it comes to your credit. Delinquencies, charge-offs and collections all seriously hurt your score.

But here's something that's really important to know:

When it comes to your FICO credit score, the one most used by lenders, what matters most is what the original creditor says on your credit report. The status and amounts owed shown on that entry will figure more heavily in your credit score than what a collection agency reports.

If the original creditor shows a charge-off with a balance still owed, you might be able to boost your score by paying off the bill and getting the original creditor to reset the balance to zero.

If the balance is already zero -- which credit bureaus say is typical when a collection agency takes over an account -- you can't improve your score by paying up.

"If the trade line balance is showing zero, you're not going to help your FICO score by paying off a collections account," said Craig Watts, spokesman for Fair Isaac Corp., creators of the FICO credit scoring methodology.

'Settling' an old debt can hurt your score

In the past, making any payment on an old, past-due debt could actually make matters worse because the action "updated" the negative mark in the eyes of the credit-scoring formula, making it look more recent than it actually was.

"Recency," or how long it's been since you've had a negative mark, matters a lot to your credit score. The more recent the problem, the more heavily it weighs against you.

In the last couple of years, however, Fair Isaac worked with the credit bureaus to change how new payments on old debts were reported, said Tom Quinn, the company's vice president for scoring. Now, the scoring formula can distinguish between the new payments and actual new delinquencies.

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