This article was written Gerri Detweiler, Credit.com’s Personal Finance Expert. Gerri focuses on financial legislation, budgeting, debt recovery and consumer savings information. She is also the co-author of Debt Collection Answers: How to Use Debt Collection Laws to Protect Your Rights, and Reduce Stress: Real-Life Solutions for Solving Your Credit Crisis as well as host of TalkCreditRadio.com.
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 credit 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 different 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 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 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 a strategy for getting out of debt in and of itself. After all, you still have to pay back the consolidation loan. But it may be one of the tools you use 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 dip or drop 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.
Credit Damage: Modestly positive or negative, fairly easy to recover
Simply calling a credit counseling agency for a consultation doesn’t impact your credit at all since the fact that you’ve sought help is not reported to the credit reporting agency. If you enroll you in a Debt Management Plan (DMP), 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 impact 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, Community Outreach Director for Cambridge Credit Counseling. Re-aging an account means it will be brought back to “current” status, so your credit report will no longer list 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 DMP 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 7 or 10 years).”
Credit Damage: Typically moderate, fairly easy to recover
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 consumer’s credit reports will list late payments before they settle. 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 DebtConsolidationCare.com. (Creditors generally charge off debts when borrowers fall 180 days behind. Charged off debts are then often turned over to collection agencies.)
He goes onto 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 ten 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 little 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 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 if necessary, 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?”