What Happens If a Credit Card Is Charged Off?

A credit card charge-off occurs when a creditor determines a debt is unlikely to be collected and removes it from their active accounts. While the creditor writes off the debt on their books, the consumer still legally owes it.

Understanding a Charged-Off Account

A credit card account is charged off after prolonged non-payment, typically around 180 days of delinquency. At this point, the creditor moves the debt from an asset to a loss on their financial statements. A charge-off does not mean the debt has been forgiven or erased; it reflects the creditor’s internal accounting decision that the debt is uncollectible through normal means.

A charge-off is the creditor’s classification of the debt. Being sent to collections refers to the active pursuit of payment by either the original creditor or a third-party agency. Often, a charge-off precedes or coincides with the debt being transferred to a collection agency, as creditors seek to recover funds for accounts they deem unlikely to collect themselves.

Impact on Your Credit Report

A charged-off account harms a consumer’s credit report. Once an account is charged off, it is reported to the three major credit bureaus: Equifax, Experian, and TransUnion. This negative mark indicates a failure to repay a debt as agreed, which can lead to a drop in credit scores.

The severity of the credit score decline depends on factors like the consumer’s credit history before the charge-off and the debt amount. A charge-off can cause a credit score to decrease by 50 to 100 points or more, especially for individuals with previously good credit. This negative information remains on a credit report for up to seven years from the date of the first missed payment that led to the delinquency, plus 180 days.

Having a charged-off account makes obtaining new credit products, such as credit cards, personal loans, auto loans, or mortgages, much more difficult. Lenders view charged-off accounts as a high risk indicator, making them hesitant to extend new credit. Even if credit is approved, it often comes with less favorable terms, including higher interest rates and lower credit limits.

Creditor and Collector Actions

Following a charge-off, the original creditor may attempt to collect the outstanding balance through letters, phone calls, or their internal collections department. It is common for creditors to sell the charged-off debt to a third-party debt collection agency for a fraction of its face value.

Once the debt is sold, the new owner, the debt buyer, assumes the right to collect the full amount owed. Consumers can expect communication from debt collectors, typically involving phone calls and written correspondence. These communications are subject to regulations under the Fair Debt Collection Practices Act (FDCPA), which prohibits collectors from using abusive, unfair, or deceptive practices.

In some instances, the original creditor or debt buyer may pursue legal action to recover the debt, filing a lawsuit to obtain a court judgment. If a judgment is granted, they may pursue collection methods such as wage garnishment or bank account levies.

Tax Considerations

When a creditor charges off a debt and forgives a portion or all of it, this canceled debt can be considered taxable income by the IRS. This typically arises if a consumer settles a debt for less than the full amount owed, and the remaining balance is forgiven. The IRS views this forgiven amount as income because it represents a financial benefit to the taxpayer.

Creditors are generally required to issue Form 1099-C, “Cancellation of Debt,” to both the consumer and the IRS if the canceled debt is $600 or more. The amount reported on Form 1099-C must be included as ordinary income on the consumer’s federal tax return for the year the debt was canceled, unless a specific exclusion applies.

One common exclusion is the insolvency exclusion, which applies if the consumer’s liabilities exceeded their assets immediately before the debt was canceled. If a taxpayer is insolvent, they may exclude some or all of the canceled debt from their taxable income. To claim this exclusion, taxpayers typically need to file IRS Form 982. It is advisable to consult with a tax professional to understand how canceled debt may affect your individual tax situation.

Options for Addressing a Charged-Off Account

Addressing a charged-off account can mitigate its negative effects. One option is to pay the full charged-off balance. Paying the entire amount can result in the debt being reported as “paid in full” on the credit report, which looks more favorable than an unpaid charge-off, though the negative mark of the charge-off itself will remain.

Another approach is debt settlement, where the consumer negotiates with the creditor or collector to pay a reduced amount to satisfy the debt. Debt collectors often purchase charged-off accounts for less than the original balance, creating an opportunity for negotiation. Any settlement agreement should be obtained in writing before payment, clearly stating that the payment will satisfy the debt in full and that the account will be reported as “paid in full” or “settled.”

When dealing with a third-party debt collector, consumers have the right to request debt validation. This involves sending a written request to the collector within 30 days of their initial communication, asking for proof that the debt is legitimate and that they have the right to collect it. If the collector cannot validate the debt, they are prohibited from continuing collection efforts.

For consumers facing overwhelming debt, bankruptcy may be considered. Filing for bankruptcy can provide a legal discharge of certain debts, including credit card charge-offs, offering a fresh financial start. However, bankruptcy has a significant negative impact on credit reports and should be considered carefully after exploring other alternatives and consulting with legal counsel.

Rebuilding Your Credit

After addressing a charged-off account, rebuilding credit is a gradual process. A primary strategy involves consistently making on-time payments on all remaining accounts, such as utility bills, rent, or any active credit accounts. Payment history is a significant factor in credit scoring, and a consistent record of timely payments demonstrates financial responsibility.

Obtaining new credit, even in small amounts, can help in the rebuilding process. A secured credit card, which requires a cash deposit as collateral, can be a good starting point. This deposit typically sets the credit limit, and responsible usage, including regular on-time payments, can help establish a positive credit history.

Another tool for credit rebuilding is a credit-builder loan, offered by some financial institutions. With this loan, money is held in a savings account or certificate of deposit while the borrower makes regular payments, which are reported to credit bureaus. Once the loan is paid off, the funds are released to the borrower, and a positive payment history has been established. Regularly checking credit reports from all three major bureaus for accuracy is also important, and any errors should be disputed promptly.