When banks lend money to borrowers, they expect to be repaid according to the terms of their loans. But sometimes borrowers fail to uphold their end of the bargain, whether they're late with payments or they fail to make those payments entirely. When a borrower neglects to make loan payments over an extended period of time, the bank that lent out that money will typically have no choice but to charge it off. A charge-off is a sort of declaration by a bank or creditor that a delinquent debt is highly unlikely to be collected. This typically happens when a borrower goes six months without making a payment.
What charge-offs mean to banks
When banks lend out money, their goal is to profit by collecting interest payments. When a borrower fails to repay a loan, the issuing bank stands to lose money. A series of charge-offs can negatively impact a bank's bottom line. When a bank reaches the point where it has given up on collecting what it's owed, it can declare a loss and write off the uncollectable amount as an expense on its income statement.
Once a bank has charged off a debt, it can still try to collect what it's owed. There's a statute of limitations for collecting bad debts, which varies from state to state. So long as the specified period of time hasn't passed, a bank can go after a charged-off debt by using internal or external collection professionals or initiating lawsuits.
Do I have to pay a loan that's been charged off?
When a bank charges off a loan, it removes that loan from its balance sheet. However, just because a bank charges off a loan doesn't mean you're no longer obligated to pay it. If the statute of limitations hasn't expired, then your bank can attempt to recoup that debt through collection efforts or a lawsuit against you. And if the bank wins in court, then it could freeze or seize your bank savings or garnish your wages.
As a borrower, it's important to know that having a charged-off loan on your credit history could significantly lower your credit score. Having a low credit score can make it difficult for you to get an apartment lease, auto loan, credit card, or even a job. And while some lenders might be willing to overlook a credit history littered with late payments, if you completely ignore your payments to the point where a bank has to charge off your loan, you have an even lower chance of being approved to borrow money going forward.
Charged-off loans will typically remain on your credit report for seven years, which is a long time to put yourself at risk for being denied credit. A far better alternative is to arrange a payment plan with your lender. Most banks would rather receive their payments late than not get them at all. By working with your bank, you could salvage your credit while making your loan payments more affordable in the process.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at email@example.com. Thanks -- and Fool on!
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.