Can a Cancellation of Debt Improve My Credit?

Cancellation of debt is often listed as a charge off on your credit report. Charged-off accounts are negative entries and will not improve your credit rating. In addition, creditors that forgive or cancel your debt typically close the credit account. In account closures, the total available credit, as well as the total outstanding debt factors of your credit rating will be affected.

Debt Cancellation Definition

A creditor will charge-off or cancel debt when you are unable to repay the loan. Typically, the cancelled debt account has been a negative entry on your credit report for up to six months and affecting the crucial payment history section of your credit rating. When the debt is cancelled, the outstanding debt factor of your credit rating is further affected. Many creditors will issue a 1099-C for the amount of the cancelled debt plus any accrued interest. Consumers must report the amount in box 2 of Internal Revenue Service Form 1099-C as income for the tax year that the debt was cancelled. Under certain circumstances, such as specific farm loans, insolvency and bankruptcy, consumers may be exempt from taxes on the cancelled debt.

Credit Rating Calculations

Thirty-five percent of your overall credit rating is calculated from your payment history. Thirty percent of the overall rating is derived from your outstanding debt. A debt cancellation negatively affects these calculations. By federal law, the negative account entry created by a debt cancellation or charge-off may be listed on your credit report for seven years. Potential lenders view the debt cancellation as irresponsible credit maintenance.

Outstanding Debt Definition

Outstanding debt is the amount of debt that you owe relative to the amount of your available credit. For example, if your total outstanding debt is $5,000 and your available credit is $15,000, you have a credit-to-debt ratio of 33 percent. When a creditor cancels your debt, the outstanding debt balance is reduced and so is the available credit. If your available credit was high and the cancelled debt was low, your outstanding debt ratio increases, which will not improve your credit rating.

Options

In lieu of cancelling the debt, negotiate with the creditor to list the account as settled and remove it completely from your credit report. A settled account is still negative as far as your credit rating is concerned. If the account listing is removed from the report entirely it can improve your credit rating. To negotiate a settlement as opposed to a debt cancellation, you may need to pay a certain amount against the balance of the account. Considering the fact that cancelled debt can increase your tax burden, the settlement payment could potentially be less than the taxes owed.