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.
Drowning in debt
Maybe you’ve seen the commercials – or found the offers in your mailbox. As the economy improves, banks and other lenders are inching back into the business of offering credit to high risk customers. Critics complain they’re preying on the vulnerable – with interest rates of up to 29 percent. NBC’s Chris Jansing reports.
Nightly News: Drowning in debt
Maybe you’ve seen the commercials – or found the offers in your mailbox. As the economy improves, banks and other lenders are inching back into the… More Maybe you’ve seen the commercials – or found the offers in your mailbox. As the economy improves, banks and other lenders are inching back into the business of offering credit to high risk customers. Critics complain they’re preying on the vulnerable – with interest rates of up to 29 percent. NBC’s Chris Jansing reports.
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).”