6/27/2012 7:55 PM ET|
How does debt relief affect credit?
If you're looking to get out from under your bills while preserving your good credit, you should know how credit-scoring agencies view various approaches.
It's a question I get all the time, "What's the best way to get out of debt?" It's often followed by a comment, "But I have good credit, and I really don't want to hurt it."
Here are the main approaches to debt relief you may be considering, along with a review of the impact they may have on your credit reports and scores. There are a couple of things to keep in mind here. Just under one-third of your credit score is made up of the debt you carry. So when you pay off debt, especially credit cards that are close to their limits, you should see improvement in at least some of the factors that make up that part of your score. But I haven't specifically included that factor in my analysis of these options, since all of them are designed to help you become debt-free (or to at least get you out of credit card debt).
Also keep in mind that it's impossible to precisely gauge the impact of a particular approach on your credit. How far your score drops -- and how quickly it bounces back -- depends on a lot of factors. If your payment history always shows on-time payments, for example, and you suddenly file for bankruptcy, your scores will probably drop more than those of someone who was already severely delinquent. Please keep that in mind, and understand that these are general guidelines, but they don't represent exactly what will happen in your case.
DIY: Snowballs and avalanches
Whether you choose to first pay off your credit card with the highest interest rate (often referred to as the "avalanche" method), or the one with the lowest balance (the "snowball" method), doesn't make much of a difference. Neither approach will hurt your credit, as long as you are making at least the minimum payments on all of your cards on time.
Credit damage: None
Getting a loan to consolidate high-rate credit card debt with a fixed-rate loan at a lower rate isn't, in and of itself, a strategy for getting out of debt. After all, you still have to pay back the consolidation loan. But it may be a tool to get out of debt faster. All things being equal, when your interest rate is lower, you can pay off your debt faster. And if your monthly payment is also reduced by consolidating, you're less likely to be late on payments, which can help you stay current with your payments and help your credit score recover more quickly if you've fallen behind in the past.
Consolidating credit cards with a loan may have a positive or negative effect on your scores. It's one of those "it depends," situations. On the plus side, if you pay off a credit card with a balance that's close to the limit, you may improve your "utilization ratio" -- the ratio that compares your credit limits with the balances you are carrying -- provided you leave the card open after paying it off. (Simply moving balances from one card to another is unlikely to do a whole lot for your scores.) On the other hand, you'll have a new loan with a balance reported on your credit reports, and most credit-scoring models will count that as a risk factor, which could mean a reduction in your scores.
The exception? If you use a loan against your retirement account to consolidate credit card debt, you're more likely to see your credit improve. Retirement-account loans aren't reported to the credit-reporting agencies, so your credit reports will show less debt but no new loan. Still, retirement loans carry other risks, so proceed with caution. (Should you consolidate your debt? Find out with MSN Money's calculator.)
Credit damage: Modestly positive or negative, fairly easy to recover
Simply calling a credit counseling agency for a consultation doesn't affect your credit at all, because the fact that you've sought help is not reported to the credit-reporting agencies. If you enroll you in a debt management plan, where you make one monthly payment to the counseling agency and it disburses payments to your creditors, however, it can affect your credit in several ways.
Some creditors may report that the account is being repaid through a credit counseling agency. If they do, it's probably not a big deal. For a while now, FICO has ignored this notation for scoring purposes. An individual lender may care, but FICO doesn't. Of course, any late payments or high balances on accounts will continue to affect your credit score.
With the help of the counseling agency, you should be able to bring your account current, and that can be a plus. "Most major creditors will re-age your accounts after you've made three on-time payments in the required amount," says Thomas J. Fox, the community outreach director for Cambridge Credit Counseling in Agawam, Mass. Re-aging an account means it will be brought back to "current" status, so your credit report will no longer indicate that you are currently behind. Since recent late payments can really hurt your scores, being up to date on your payments while allowing the past late payments to age will be a plus, especially over time.
Finally, you'll have to close your credit cards when you enter into a debt management plan, and that will likely lower your scores. How much it will hurt depends on everything else in your credit reports, of course, including whether you have other open, available credit such as a car loan or mortgage that you are paying on time. The impact may not be immediate, either, says Barry Paperno, community director for Credit.com. That's because "balances and limits won't necessarily change right away, and utilization will be the same as before closing accounts." He goes on to explain, "Closing an account, in and of itself, isn't considered negative by the score. Over time, however, having closed the cards can hurt the score, as closed cards with zero balances are excluded from utilization and ultimately fall off the credit report much sooner than open cards that have been paid off."
"Plan on getting a secured card when you complete the DMP," he suggests, "so that as long as you keep a low utilization percentage on that one card, you can achieve a good score -- with any lates fading well into the past. Also, your old closed cards will continue to contribute positively to your overall length of credit history for as long as they remain on your credit report (typically seven or 10 years)."
Credit damage: Typically moderate, fairly easy to recover
More from Credit.com:
- Is one late payment really that bad?
- 8 surprising things that affect your credit
- What's really in your credit report?
Debt negotiation or settlement
When you settle a debt, you pay less than the full balance you owe. Since creditors typically won't settle debts with consumers who are making their payments on time, most consumers' credit reports will list late payments before they are settled. On top of that, "most creditors will report the settlement as something like 'paid less than full balance' if you settle the debt before it has been charged off," warns Michael Bovee, community manager for Debt Consolidation Care. (Creditors generally charge off debts when borrowers fall 180 days behind. Charged-off debts are then often then turned over to collection agencies.)
He goes on to explain: "When you settle a charged-off debt, getting it reported (with a) zero balance due will not, in and of itself, help your credit, because the damage has already been done." But it could help you ward off further damage from, say, a potential lawsuit. For an account that hasn't been charged off yet, settling it before it gets to that point can help prevent it from being turned over to collections and adding another negative item to your credit reports.
Brad Stroh, co-CEO of Freedom Debt Relief adds, "Debt settlement hurts people's credit scores but helps their credit profiles. (It's) worth considering, for anyone struggling to pay a lot of credit card debt, despite its negative effects on credit scores. It is far easier to rebuild one's credit than to get out of debt, and people carrying a lot of debt likely have credit problems already."
Credit damage: Severe, will take time to recover
It's well known that filing for bankruptcy will hurt your credit scores. Bankruptcies can be reported for up to 10 years from the date of filing. What's not as well understood is that credit scoring algorithms typically segment consumers in subgroups called "scorecards." So if you've experienced a significant negative credit event, such as bankruptcy, for credit-scoring purposes you are probably being compared with other consumers who have also been though something similar. Not only may that be a bit comforting, it can also mean you have a good shot at improving your credit scores if you make a real effort to rebuild good credit after your bankruptcy is discharged.
It's also worth noting that Chapter 13 bankruptcies, where you typically pay back some or all of your debts over a period of three to five years, may be a little easier to recover from, at least as far as your credit is concerned. That's because they come off credit reports seven years after the date of filing. So if it takes you four years to complete your Chapter 13 plan, you have to wait only three more years before the bankruptcy disappears from your reports. (Financially, though, you'll probably end up paying more in a Chapter 13 bankruptcy than in a Chapter 7, where you wipe out all or most of your debts, so make sure you discuss both options with a qualified consumer bankruptcy attorney.)
Credit damage: Severe, will take time to recover
Getting back on track
Whichever method you choose, keep in mind that the ultimate goal is to pay off your debt so you can save and invest for future goals. The hit to your credit may be worth it if it means you can finally get your balances to zero. Monitor your credit, consider getting a secured card, and keep it in perspective.
"People just worry about their credit too much," says Fox. "If your couch is on fire, would you not throw water on the fire because you don't want to damage the upholstery?"
More from Credit.com:
VIDEO ON MSN MONEY
I chose "negotiation and settlement" for my relief of debt. This allowed me to pay what I owed without paying all the late fees and interest which were enormous. I had 4 credit cards which totaled about $20,000 and I paid it off in 3 years all except one, Bank of America which was a hard ball to crack. For the 3 years they refused to even talk to my negotiator. I did not have an attorney because I couldn't afford one but I had daily contact from the company I went with.
I was schooled in what to say to creditors when they called, I was told about the laws of what the creditors could and could not do. Did you know it's against the law for creditors to call you at your place of work? 99.99% of the creditors action is intimadation ! I even had to go to court and was schooled on what to say, how to type my own court forms and when I left the court room I knew Perry Mason couldn't have done better. Bank of America finally wrote off the balance they thought I owed. My credit is good now.
Having a lower debt to income percentage (DTI) does indeed help you qualify for new credit products and will raise your credit score over the long term as compared to having balances still owed and unresolved. My statement about the act of settling a debt "does not in and of itself" raise your score in the above article remains true.
I cover the DTI issue combined with debt settlement and access to new credit products fairly thoroughly in an article on the Consumer Recovery Network site. The article compares credit score impacts with debt settlement, bankruptcy and credit counseling services.
I am unable to post a link to the article. If you do a search for the following phrase using the quotes, it should show in the first search results:
"your credit report and score is going to get clobbered"
Michael Bovee ofDebt Consolidation Care is wrong when he says "when you settle a charged-off debt, getting it reported (with a) zero balance due will not, in and of itself, help your credit, because the damage has already been done..."
In fact, about 30% of your credit score is based on the amount of debt you are carrying. So, getting the balances down to zero DOES in and of itself help the credit score.
And this guy is supposed to know credit? Watch out folks!
I have always believed that a Credit Score doesn't measure behavior....rather it 'controls' behavior......Think about it.....you close an account; start paying cash for purchases; pay off balances; obtain a new credit card and not use it; don't incur anymore debt......see what happens to your credit score......you won't be able to buy anything on credit because the score(s) will be so low.
Keep spending America....keep the same banks in business that we bailed out and now are on spending (oh wait, investment) sprees, once again.
Want to blame someone.....take a good look in the mirror.
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