Long-term disability income insurance (LTD) replaces a percentage of an individual’s job earnings when a disability forces them to leave the workforce. The percentages vary somewhat, but ranges from 50% to 80% are typical. Very few people are prepared for a sudden drop of 20% or more in their income, so many LTD recipients find themselves with sudden questions about their financial futures, like: “Does receiving LTD harm your credit?” The truth is that there is no direct long-term disability effect on credit rating, but individuals who are approved for long-term disability benefits often do see some LTD impact on credit scores assessments, because the LTD benefit payments are significantly less than the income they were earning previously. These and other factors can lead to financial difficulties for people on LTD fixed incomes, even though long-term disability and credit scores are not formally linked. Understanding some of the ways that long-term disability and credit scores interact may help you develop effective financial management strategies for navigating these challenges.
What Are the 5 Cs of Credit Assessment?
Lenders use a framework called the “5 Cs of Credit” as a shorthand for identifying the factors they scrutinize closely in determining whether to approve a loan. Sometimes this credit assessment is also used in setting interest rates for individual borrowers and in setting maximum spending limits for credit cards or store credit programs. The 5 Cs are:
- Character
- Capacity
- Capital
- Collateral
- Conditions
Considering the 5 Cs in combination helps lenders to develop a more holistic picture of the risk associated with an individual borrower for a particular loan than can sometimes be represented by the single number of a credit score.
Character
Although it is common to think of an individual’s character as the product of his or her integrity, compassion, values, and commitment, underwriting teams setting standards for credit approval frame character differently. In lending circles, “character” is usually confined to an individual’s credit history, and is the element of the 5 Cs most closely related to the person’s credit score. Factors that can affect character in this sense include the number of loans previously held, how many have been paid in full, and whether the loan applicant has any history of late payments or defaulted loans. To the extent that the changes in income and lifestyle associated with claiming LTD benefits can easily result in missed bills and late payments, individuals seeking credit approval can sometimes see an indirect long-term disability effect on credit rating.
Capacity
Capacity is defined by two key variables: An individual’s income and the existing debt burden that makes some of that income automatically available for other expenses. In this sense, capacity is similar to the concept of disposable income with which people outside the financial services industry are more likely to be familiar. Banks and other financial institutions often speak of capacity in terms of “DTI,” which stands for debt-to-income ratio. DTI is also important for certain other considerations, such as applying for rental housing. Individuals who have recently gone on disability may be disproportionately likely to wonder “Does receiving LTD harm your credit?” in relation to rental housing applications, due to the lifestyle changes many disabled people may make to accommodate their decrease in incomes. Depending on the nature of the disability, these individuals may also seek rental housing because of the comparatively lower maintenance demands associated with rented properties.
Collateral
Even if you do not currently owe money on a secured loan, chances are high that at some point in your financial history you will have had some form of debt that was secured with collateral. For most people who have primarily personal debt, the collateral or “security” on a loan is usually the item the loan is intended to help purchase. Home mortgages are perhaps the most recognizable examples, because for most people the home that is mortgaged is the one that is purchased with the loan. The auto loans used to finance many personal vehicles also work on this principle, and to a certain extent so do pawn shops. Sometimes, however, it is possible to secure a loan using a form of collateral other than the valuable property the borrower is using the loan to buy.
Borrowing Against Property in Your Possession
Individuals who borrow against their investment stocks are typically using these stocks as collateral to secure a loan they use for some unrelated purpose. At the other end of the economic spectrum, title loan services also accept ownership of some form of valuable property as collateral for a loan the applicant wishes to use for some purpose other than buying the item offered as collateral. Often these title loans are short-term, high-interest arrangements in which an individual who needs cash to cover emergency expenses pledges the title to their personal vehicle as security for a loan. They can be financially risky, but because the resale value of the property is often quite high compared to the loan amount, title loan businesses are often willing to lend money to individuals whose LTD impact on credit scores assessment has made it difficult for them to borrow money from banks.
Does Repairing LTD Harm Your Credit? Understanding Collateral and Unencumbered Property
Depending on how much property you owned free of debt prior to applying for long-term disability, your collateral relative to your capacity may be high. Any property that you own without debt, such as a home or car that has already been paid off, will count in your favor as collateral. For individuals who had a high ratio of collateral relative to their debts prior to becoming disabled, the fact that collateral generally remains unchanged even when capacity declines can sometimes buffer the long-term disability effect on credit rating for individuals who need to secure loans after becoming disabled.
Capital
Similar to collateral, capital is a resource already in a credit applicant’s possession. However, whereas collateral consists of physical property, such as real estate or vehicles, capital refers to monetary assets. Savings and checking accounts are two examples that many people rely on every day.
One of the many financial challenges associated with developing a disability mid-career is that often the attempts to get a diagnosis and treatment can prove quite expensive, even with health insurance. If the review process for an individual’s long-term disability claim encounters significant delays, then even individuals who had substantial capital prior to becoming disabled may find themselves very short in this area by the time their LTD benefits are approved, leading to an indirect LTD impact on credit scores assessments. Additionally, because LTD benefits only replace a specified percentage of the policyholder’s pre-disability wages, it can be very difficult for people living on long-term disability to improve this aspect of the relationship between their long-term disability and credit scores.
Conditions
Conditions may be the element of the 5 Cs of credit that is most immediately susceptible to a negative LTD impact on credit scores assessments. This is because the “conditions” a lender may consider in evaluating the potential risk associated with a loan can involve a host of factors, not all of which are as readily quantifiable as elements like capital or capacity. As long as the conditions weighed in the loan decision do not include factors that violate consumer protection laws, in most cases they are likely to be considered fair game.
Sometimes in these situations it can be helpful to work with a co-signer. Even when the long-term disability effect on credit rating does not prevent an individual from being approved for a loan, a co-signer who has a higher credit score and especially higher capacity than the applicant may sometimes result in a lower interest rate, thereby reducing the total cost paid for the loan.
How Do Credit Ratings Work?
Generally speaking, borrowers with higher credit ratings get lower interest rates and higher spending limits. Borrowers with lower credit ratings may be charged higher interest rates on the money they borrow. For types of borrowing that are calculated as rolling tallies instead of fixed amounts, such as store credit, credit cards, and “buy now, pay later” services, borrowers with lower credit scores often also have lower spending limits than their peers with higher credit ratings.
Does Disability Affect Credit Score?
Sometimes it can be easy to conflate having a disability with being on disability benefits. For individuals who “go on disability” because their condition has made them unable to continue working, the two experiences are obviously related. This can be one reason why having an LTD claim denied often leaves the person who filed the claim feeling not just frustrated and financially stressed, but personally invalidated and hurt. Many people who have to go through the process for appealing denied long-term disability claims report feeling insulted and humiliated, as if they are being accused of lying about their conditions and “faking” disability to get out of what may often have been a deeply cherished and fulfilling career.
LTD Impact on Credit Scores: Assessments Based on Direct vs. Indirect Factors
From the standpoint of credit reporting, however, long-term disability benefit payments and the condition that leads an individual to qualify for these benefits are completely separate. Neither will affect your credit score directly, but any impact either has on your overall income can impact your total credit rating indirectly, just as would be the case with any other factor that changed an individual’s income and debt level.
Does Being on Disability Affect Your Credit?
Disability benefits typically cover only a portion of the income a person loses when they have to leave work due to disability, so the reduction in income will affect the capacity factor within the 5 Cs. In many cases, the time it takes to apply for long-term disability benefits and get a claim approved, while also making lifestyle adjustments to accommodate the change in income, can lead to high levels of accumulated debt. Because capacity takes into consideration an individual’s debt-to-income ratio, an increase in debt that occurs simultaneously with a drop in income will lower a lender’s estimation of that person’s capacity.
“Conditions” can be one of the more difficult credit rating factors to quantify. By its nature, this element is intended to help lenders and underwriting teams account for the many variables beyond simple numbers that can affect whether a loan is a worthwhile risk in a particular situation. However, two considerations lenders often examine are the amount of time an individual has been in his or her current job position, and the general trajectory of earnings for that role and industry. Does receiving LTD harm your credit directly? No, but an unavoidable feature of LTD impact on credit scores assessments is that receiving long-term disability benefits does alter the conditions under which you will be operating when you apply for a loan.
What Are the Cons of Claiming a Disability?
Having a disability often limits earning opportunities, even if the individual is eventually able to return to work. Even though having a disability does not by itself trigger an interaction between long-term disability and credit scores, a lender’s perception of limitations in your potential for career advancement can color their interpretation of your conditions in a credit evaluation, even if you are not currently receiving LTD benefits. Disabilities are unfortunately not one of the categories explicitly protected under the Equal Credit Opportunity Act (ECOA), so in some cases an estimate of your conditions may affect your credit approval independent from any LTD impact on credit scores assessment.
Another way that having a documented and acknowledged disability may sometimes adversely affect credit is through the sheer expense that is often involved in navigating the world with a disability. Maintenance medications, adaptive devices, and frequent medical appointments can all create a significant financial burden, which in most cases health insurance alone will not cover. When these expenses result in disability-related debt, they can also decrease lenders’ assessment of the person’s capacity. Because this reduction in capacity also makes it harder to save money over time, people with disabilities often find it harder than their peers to save money for the future, even if they are actively working in full-time jobs. Individuals who eventually have to leave work due to the worsening of a progressive condition may therefore see those cumulative factors indirectly reflected in a long-term disability effect on credit rating.
Long-Term Disability and Credit Scores: Does Receiving LTD Harm Your Credit?
If you are worried about a long-term disability effect on credit ratings, one of the most important things for you to know is that any LTD impact on credit scores assessments will usually be indirect. Many people applying for long-term disability benefits ask: “Does receiving LTD harm your credit?” The answer is that qualifying for LTD benefits does not, by itself, have a negative impact on an individual’s credit rating. Long-term disability and credit scores do not share a direct cause and effect relationship. However, the circumstances many people experience as a result of becoming disabled, including the journey to getting their long-term disability claims approved, can often contribute to credit ratings that are lower than the same individuals may have been used to maintaining. Even a fairly expansive LTD policy will only replace a portion of your former income, so careful financial management strategies will likely play an important role in helping you manage your long-term disability benefits. These strategies can be especially important during periods of increased inflation, and as you approach retirement age. If you are considering ways to supplement your income, or preparing for the transition from LTD to retirement, you may wish to consider speaking with a disability lawyer to review the terms of your specific policy and make sure you understand all your financial options.
