Does Paying Off a Defaulted Loan Improve Your Credit?

Lenders and other creditors report your credit information to the credit bureaus. The bureaus then condense this data into an individual credit report. Your credit report determines your FICO credit score. A defaulted loan will negatively impact your credit score, so it's helpful to know if paying off the loan will improve it.

FICO

According to FICO, your credit score is based upon five specific factors. The largest component of your score is the payment history on your credit accounts. This represents 35 percent. The next biggest factor is the amount of debt that you have, which is 30 percent. The length of your credit history is 15 percent, 10 percent is the mix of credit types on your credit report, and the remaining 10 percent is the level of new credit you've applied for recently.

Significance

Late payments on a loan are reported to the credit bureau and will damage your credit score. One 30-day late payment can drop your score by as much as 110 points, according to MSN Money. The later the payment, the more damage occurs to your credit. Paying off a loan stops the loan from becoming further delinquent and can minimize further damage to your credit score. Once a loan reaches 150 days late, however, the lender may charge it off as a loss and once that happens, the account cannot be rehabilitated, or brought to a positive status. It will appear as a charge-off on your credit report. If you later pay it, it will still have a status of charge-off but with a notation that it was paid.

Considerations

FICO considers how much debt you have in the calculation of your FICO score. If you have a defaulted loan on your credit report that reports a balance, that outstanding balance is included in the calculation of your score. Generally, the less debt you have, the higher your score. FICO suggests that to improve your score, pay down the balances on installment accounts, such as loans. Paying off the loan, even if it's in default, will lower how much debt you have overall and this will improve your score.

Warning

If you settle the defaulted loan instead of paying off the full balance, the lender will report that to the credit bureau. The status of your loan will read as paid-settled, not paid as agreed. This is significant because future lenders may look unfavorably at a borrower who settles a debt for less than owed instead of paying the total amount due. If the amount the lender forgives is $600 or more, the lender may report that to the IRS as income to you. You will then receive a 1099 and have to include that income on your tax return and possibly pay taxes on it.

References

• myFICO: What's In Your Credit Report
• myFICO: What's In Your FICO Score
• MSN Money; 5 Ways To Kill Your Credit Score; Liz Pulliam Weston; November 2009
• myFICO: What Are The Different Categories Of Late Payments and How Does Your FICO Score Consider Late Payments?
• myFICO: How to Repair Your Credit and Improve Your FICO Credit Score
• Bankrate.com; Reporting Forgiven Debt on Your Taxes; Steve Bucci; March 2006

Resources

• myFICO: Credit Basics