Question: I have almost $4,000 on my credit cards and I can barely make the minimum payments. It’s a mess, but the more I look at my options, the more confused I get. There’s “credit counseling” and “debt counseling” and “debt consolidation” and “debt management” and “debt settlement.” Do debt relief programs hurt your credit? And if so, how bad? I don’t want to pay off my credit cards and then face a bunch of new problems.

— Paul in Oklahoma

Howard Dvorkin CPA answers…

I hear you, Paul. Debt is a complex problem, but thankfully, the solutions aren’t as complex as many folks make them out to be.

Let’s tackle your confusion first, then ease your fears.

In order, you mentioned these terms…

Debt relief programs defined

Credit counseling and debt counseling

These are two terms for the same thing. I prefer credit counseling because it’s more precise. A consumer credit counselor evaluates your debts, credit, and budget to help you find the best option for relief. They also provide free financial education that will help you rebuild your score and learn better credit habits moving forward. Credit counseling isn’t a debt solution, in and of itself. It’s really a service that helps you find the right solution for your needs. At the end of a free credit counseling session with a nonprofit credit counseling agency, they may recommend any of the following:

  • A debt consolidation loan
  • A debt management program
  • Debt settlement
  • Bankruptcy

Debt consolidation

If you have balances on several credit cards, and each is charging a different interest rate, you can save by rolling them all into one lower-interest monthly payment. There are a few ways to consolidate credit card debt, each with its own pros and cons. Picking the right one depends on how much you owe and your credit score.

Debt management

This is short for a debt management program, or DMP. If you call a credit counseling agency, they might recommend you pursue one if your credit score isn’t high enough to use solutions like debt consolidation. The credit counseling agency helps you set up a repayment plan that works for your budget. Then they act as a go-between for you and your creditors. They negotiate to reduce or eliminate interest charges and stop fees applied to your debt. Then you make one payment to the agency each month and they distribute the money to your creditors on your behalf. The catch? You must close your credit cards, but you can still use a debit card.

Debt settlement

Debt settlement is a solution that’s basically one step shy of bankruptcy. You settle your outstanding credit card debt for less than you owe, in some cases for pennies on the dollar. Why would your debtors agree to take less? Because they know they might not get anything, and something is better than that. However, the Federal Trade Commission ranks unscrupulous debt settlement firms as one of the Top 15 most common purveyors of consumer fraud. So thoroughly investigate anyone offering this service to make sure the company is legit.

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How these debt relief programs affect your credit score

I have good news, Paul, and even the bad news is good…

Credit counseling doesn’t affect your credit score at all. The credit bureaus don’t care if you’ve consulted a professional counselor seeking advice on how to overcome challenges with debt  — in fact, they’ll privately be pleased to hear it. The only notation in your credit report that you received free credit counseling will be a “soft” credit inquiry. When you get credit counseling, they check your credit report to help them evaluate your situation, but this soft pull doesn’t affect your credit score.

Debt consolidation will usually help your credit score, as long as you make all the payments on the consolidated debt on time.  That’s because “payment history” is 35 percent of your score, according to FICO. That eclipses the 15 percent for “length of credit history,” which might take a hit if you close some accounts once you consolidate, particularly if you’ve had those account for a while. However, not all consolidation options require you to close your old accounts.

Debt management programs may actually improve your credit score over time. Remember what I said above about the factors that comprise your score? Your payment history is the biggest chunk at 35 percent, but second is “amounts owed” at 30 percent. Well, each payment you make is lowering that amount. A debt management program may have a slightly negative effect on your credit because it closes your credit card accounts. But as with consolidation, that negative is usually outweighed by the positive payment history you build and the gradual decrease in what you owe.

Debt settlement almost always negatively affects your credit score, although in some cases you may be able to minimize the damage with proper negotiation. Like bankruptcy, you’re not paying back everything you owe, and credit bureaus don’t like that. However, it’s better than leaving your accounts in charge-off status or having unpaid collection accounts on your credit report. You will generally have a faster, easier time building credit if you’ve addressed all your current challenges with debt.

So, is getting debt relief bad for your credit?

If you’re focused on your credit score, debt settlement is the only activity on this list of debt relief programs that you should worry about.

Why? Because even if a DMP makes a dent in your credit score by closing your accounts, the alternative is far worse: You don’t pay off those out-of-control credit card bills, and eventually, you may be forced into debt settlement or bankruptcy.

SolutionCredit Effect
Credit counselingNeutral (no credit score effect)
Debt consolidationPositive, as long as all payments are made on time
Debt managementPositive or neutral, may see a slight decrease if old accounts are closed
Debt settlementNegative, 7-year penalty for each debt settled

If you want the low-down on which program is right for you, call us at 1-800-810-0989. We’ll explain them all in plain English and without high-pressure sales tactics. In fact, Debt.com doesn’t offer these services. We simply refer you to highly rated companies that do.

So don’t have confusion or fear. Find your inspiration.

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Article last modified on September 8, 2020. Published by Debt.com, LLC

contributor

Howard Dvorkin, CPA

CPA and Chairman