What is Financial Hardship? Common Causes and How to Mitigate Credit Damage

You can fix your financial problems, and there are plenty of resources to help. That’s the message I want to get across as we tackle the most frustrating thing about money: not having enough of it.

Your creditors agree to offer you loans or credit cards in return for your promise to repay. Financial hardship is your inability to live up to that promise — often through no fault of your own.

Financial hardship is the inability to meet financial obligations. This can be due to reduced income, increased expenses, or unexpected life events such as illness, job loss, or an economic downturn.

Some of you may be here because you’re facing a crisis or think one might be on the horizon. Understanding the causes and implications of financial hardship is essential, even when your finances are healthy.

That’s because we can’t predict the future, no matter how hard we try. But understanding financial hardship and what to do if you experience it is a great way to prepare. So, let’s dive in to this seldom-discussed topic.

I can’t offer much help if you’ve simply run up too much debt and decided not to repay it. But I firmly believe most people facing financial hardship are up against something bigger than themselves. Let’s start by understanding why challenges arise.

Job Loss or Reduced Income

One of the implications of living in a free-market economy is that our jobs aren’t guaranteed. Businesses are sometimes obligated to slash wages and employment to respond to market changes. You may experience an impact if your company falls on hard times.

You’re in a pretty sweet situation if involuntary unemployment or income loss has no effect. It can mean drastic budget changes for the average two-income family.

The need to prioritize wants versus needs becomes more urgent when unemployment or income loss becomes chronic. Loan payments may need to take a back seat when family necessities are threatened.

Unexpected Medical Expenses

Unpredictability extends even more acutely to the intersection of money and health. Even the most dedicated fitness buffs suffer unforeseen medical emergencies. Meanwhile, chronic public health conditions impacting our overall productivity and life expectancy are on the rise.

Unfortunately, health insurance doesn’t always protect policyholders.

And while the Affordable Care Act covers many low-income individuals and those with preexisting conditions, some states, including Florida and Texas, still refuse federally funded Medicaid expansion offered under the law.

Unexpected or uncontrollable medical expenses may arise suddenly or accrue gradually from ongoing treatments. Either way, high medical bills can drain savings and turn everyday financial obligations into a nightmare.

Major Life Events and Disasters

While most of us figure out how to manage the bumps and bruises of life, all of us eventually battle something we can’t win against. Sudden changes in life and the way we live can have an enormous impact on our finances.

For example, divorce can cause a financial fracture in addition to a family heartbreak, wreaking havoc on a couple’s finances for many reasons, none of which are good.

Even more profound is the death of a family breadwinner. Life’s imperatives force grieving families to think of numbers at a time of maximum stress. Likewise, the loss of one’s home due to a natural disaster can provoke lasting consequences because of financial decisions made under duress.

Profound loss carries a cost. I try to remember that significant life events are unpredictable but inevitable and plan accordingly.

There’s no way around the fact that your lenders will contact you as soon as you stop holding up your end of the credit bargain. Depending on how things go, that could have an impact on your credit score that could be hard to overcome.

Late Payments

Missing loan or credit card payments can result in penalties and adverse credit reporting. It’s as simple as that. If you miss a payment by a few days, you’ll have to deal with a late fee, but when your tardiness gets to 30 days, that’s when creditors report a missed payment to the credit bureaus.

Creditors generally measure account delinquency in 30-day increments. Negative credit score impacts ramp up from an initial ding at the first past due date. Expect impacts of increasing severity every 30 days after that — in addition to copious emails, texts, and phone calls.

That’s in addition to late fees, interest rate increases, and credit limit adjustments (not in a good way). Lateness also signals you’re a high-risk borrower and prices you out of the most affordable credit. There’s no scenario where failing to make your payments on time is a positive.

Defaults

Lenders and credit card issuers generally give up on delinquent accounts after six months, declaring loans in default and charging them off on their books as losses. The delinquency and default process can cause your credit score to drop by at least 50 points and often by as much as 100.

What’s more, the default record in your credit history continues to impact your score for up to seven years.

Loan delinquencies and defaults produce successively greater impacts on your credit score.

That’s more than enough time to lock you out of a life-changing financial opportunity if one ever comes around.

Most lenders sell portfolios of defaulted loans to collections agencies for a fraction of their original value. The agencies nag borrowers to extract everything they can out of their portfolios. Many who default on loans receive further contact from collections agents.

Increased Credit Utilization

A less immediate impact of financial hardship may be increased reliance on credit cards. It’s worth noting because the three major U.S. credit bureaus — Equifax, Experian, and TransUnion — attach significant weight to credit utilization in their credit score models.

Credit utilization refers to the ratio between credit used and credit not used. The lower your utilization percentage, the better your credit. Ideally, this percentage is below 30%, but FICO awards the highest credit scores to those with utilization ratios of just 1%.

Putting extra debt on your cards to tide you over during a crisis may not have the sudden, drastic impact of delinquency or default. But high utilization can wear you down gradually because — again — lower credit scores result in higher loan costs.

And if the financial hardship isn’t over before you’ve reached the end of your credit limits, you may be staring down late payments and defaults anyway.

You may feel you have no choice but to put extra debt on your cards. But many alternatives are almost invariably better. The common theme among them is anticipation.

You may be able to minimize credit score fallout from financial hardship by contacting your creditors and seeking reputable help everywhere you can.

Your creditors don’t want you to fail. They lose twice when that happens — once when you default and again because your lower score forces them to lock you out of future beneficial lending opportunities.

When you reach out, it helps them turn one of those losses into a win for both sides.

Hardship Programs

Many creditors are willing to work with borrowers facing financial hardship. Contact them and explain your situation. Most lenders make a variety of hardship programs available to struggling borrowers.

Loan modification programs reduce interest, extend repayment terms, and even defer payments for a time to lower the monthly payment amount.

Mortgage and student loan issuers are particularly likely to recommend forbearance to prevent default during a crisis.

Credit card issuers, utility providers, and others are also willing to work with you individually. Successful completion of a hardship plan is a positive for your credit score.

Debt Repayment Plans

You can also work with a nonprofit credit counseling agency to create a debt-repayment plan that consolidates your unsecured debts into one monthly payment. Lower interest rates and fee waivers are available to make payments more affordable.

Some lenders offer consolidation loans that accomplish the same goal.

Be careful because those are commercial products designed to make a profit, and rates and terms can be disadvantageous.

Debt repayment plans usually last three to five years. Nonprofit credit counselors are disinterested third parties capable of devising a holistic solution based on the needs of each borrower.

Government Assistance

It’s usually not a good idea to work with commercial debt settlement firms offering to settle your accounts for significantly less than the principal. The negative impact of their actions on your credit score makes that option a no-go for most.

A better choice is public assistance because it keeps you moving forward. Unemployment benefits and healthcare assistance compensate for income loss and sudden expenses. Grants and discounts can help with housing costs.

There are many safety net programs for financial support. Find a nonprofit counselor or resource to help you negotiate the online complexities.

I hope you see by now that everything is definitely not lost if a financial reckoning is approaching for you. You may think it’s counterproductive to save for the future while repaying the debts of the past. Many debt-repayment strategies build in future savings and everyday nonessentials.

Build Emergency Savings

First, you must put the fundamentals in place.

Step one is to build an emergency savings auto-deposit into your budget.

Varying web statistics all point to the same thing. No matter how you slice and dice it, millions of Americans lack enough extra money in checking or savings to fix a flat tire.

To get your safety net going, calculate your essential monthly expenses and save enough to fund three to six month’s worth of daily existence.

Set and forget a paycheck auto-deposit to a savings account. That way, it’ll be there to help anytime you would have had to resort to credit to get something done.

Budget for the Unexpected

There’s also no getting around the reality that productive personal financial management requires you to manage your finances.

Land on a budgeting method or tool. List your income sources and your fixed and variable expenses. Plan for the unexpected by working some cushion into your budget.

Zero-based budgeting assigns every dollar to a purpose. Savings can and should be part of that. Track spending regularly and use categories wisely.

There’s so much coaching and so many resources available online that you may feel flooded and want to give up, but don’t. Just keep looking until you find someone you can trust to teach you what you need to know. You stand to gain invaluable peace of mind and the confidence to do more and more.

Insurance Coverage

The icing on the cake is acquiring adequate insurance to help cover your expenses and protect your financial health.

Health insurance may protect against sudden medical costs. Life insurance can protect against the loss of a breadwinner. Disability insurance can compensate you or a loved one for the inability to earn income.

Insurance for car owners and renters also carries protection. Choose the maximum coverage that fits your budget goals, giving every line item the emphasis it deserves.

Do your best to avoid underinsuring while balancing premiums against deductibles and fitting coverages to your needs.

Review and potentially update your insurance policies as renewal time approaches and after significant life events. Keep a close eye on your insurance so it works for you, not the other way around.

There’s a lot of potential drama behind a loan or credit card agreement. Lenders and issuers leap into action to secure their investment if you go off the rails as a borrower. The credit reporting industry also anxiously awaits news of your timely payments. Your future hangs in the balance.

But no one wants you to fail. Everyone wants a happy ending. There’s an immense financial community dedicated to helping you transform your finances. You’ll benefit more when you understand the nature of your hardship and ask for help.