What Kind of Debt Consolidation Won't Hurt My Credit?

by Jayne Thompson
Closing your credit removes the temptation to spend, but this may harm your score.

There are ways to manage your debt without harming your credit score. It all depends on how well you're handling your debt, and how you chose to bring your debt repayments into one affordable monthly payment. Before you consolidate, it's worth talking through your options with a credit counseling agency. Your initial consultation has zero effect on your credit, as it is not reported to the credit bureaus.

Debt Management Barely Matters

If you enroll in a debt management plan, you'll make regular payments to a credit counseling agency, which will then share this money among your creditors. Some of those creditors may inform the credit bureaus that your account is being repaid in this way. However, FICO, the standard credit score in the U.S., disregards debt management plans when it compiles your score from your credit report. That's not to say that debt management arrangements have zero impact on your credit. Late payments and high balances will still appear on your report, and typically lower your score.

Consolidation Controls the Risk

Loan consolidation takes your existing debts and turns them into a single loan with a lower overall interest rate. In theory, you'll have a lower monthly repayment, which means you're less likely to default on your loan. Staying current with your payments should set your credit score on the path to recovery. Moreover, your utilization ratio -- a ratio that compares credit limits to balances -- will improve if you use the consolidated loan to pay off a maxed-out credit card. On the downside, your credit score will reflect the additional risk you've taken on by signing up for a new loan.

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Snipping the Cards

Simply closing your lines of credit, such as your credit cards and car loans, will likely lower your credit score. FICO evaluates both the positive and negative information in your credit report before ascribing an overall score: 10 percent of your score relates to the types of credit you have in use, and 15 percent to the length of your credit history. Having closed cards damages both of these allocations, as closed cards with zero balances fall off your credit report sooner than open cards. Moreover, when you close a credit account, you're cutting off avenues for establishing a good track record of making timely payments, which raises your score in the long run.

Bankruptcy

Knocking up to 220 points off your credit score, bankruptcy devastates even the healthiest credit record. Chapter 13 bankruptcy, in which you pay back some of the debt over a three- to five-year period, has a slightly gentler effect. This falls off your report after seven years from the date of filing, whereas Chapter 7, which involves asset liquidation, sticks for up to 10 years. On the plus side, FICO categorizes people into subgroups. While it bases every credit score against five risk-assessment categories, it factors these categories differently for each consumer group. So if you've suffered bankruptcy, for credit-scoring purposes, you will be compared against similar consumers.

References

About the Author

A former real estate lawyer, Jayne Thompson writes about law, business and corporate communications, drawing on 17 years’ experience in the legal sector. She holds a Bachelor of Laws from the University of Birmingham and a Masters in International Law from the University of East London.

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