Will A Debt Management Program Ruin My Credit Score?

credit score effectParticipating in a debt management program will have a positive effect on your credit score for several reasons, the most vital one being that it teaches you the importance of on-time payments.

While there are several other factors in a debt management program, just as there are several other factors in calculating a credit score, the overriding goal of a DMP is to get consumers in the habit of paying bills on time every month.

Coincidentally, on-time payments are the single biggest factor in determining your credit score!

The FICO credit score, the one used by 90% of business lenders, uses five factors in calculating a credit score. On-time payment history, which counts for 35% of your score, is the biggest component of the five.

The other four FICO factors: amount owed (30%), length of credit history (15%), types of credit used (10%) and new credit (10%) are all affected by a debt management program, but none have the impact that an on-time payment history has on your score.

So, forget what you’ve heard about debt management programs ruining your credit score. Just the opposite is true. A debt management program is a great way to manage your credit score. Here is a look at how it impacts each component.

History of On-Time Payments

The primary reason people look into debt management programs is because they haven’t been able to keep up with payments on their credit cards. Debt management program clients tend to score high in this category because the program stresses on-time, automated and affordable monthly payments. InCharge credit counselors get you in the habit – and keep you in the habit! – of paying bills on time. The real goal is help you establish a pattern of on-time payments, which will benefit your credit score.

Credit Utilization

This is a tricky category because most debt management programs ask you to close all but one credit card account and that could have a temporary negative affect. Credit utilization is the percentage of available credit you use each month and experts want that number to be 30% or less. The more credit cards you have open, the easier it is to stay under the 30% utilization boundary. Closing a card account could have the opposite effect, though only temporarily.

For example, if your credit card has a $5,000 limit and you spend $3,000 this month, you have utilized 60% (3,000 ÷ 5,000 = .60) of your available credit. That’s too much. However, if you have three credit cards, each with a $5,000 credit limit and you spend the same $3,000, you have used only 20% (3,000 ÷ 15,000 = .20) of your available credit. That’s very acceptable.

Unfortunately, if you close two of those cards you effectively force yourself above the 30% credit utilization line. However, because the cards are frozen, you should not be accumulating any more debt with them. Instead, you are making payments and as debt decreases, so does your credit utilization percentage.

When people ask: Why does paying off debt lower my credit score? This is what they’re talking about. The fact is, it’s a short-term setback that doesn’t amount to much more than a tap on your credit score. The goal of a debt management program is to pay off your credit card debt, so over time, if you stick with the program, you should see your credit utilization falling into optimal ranges of 30% or less.

Length of Credit History

Length of credit history is the number of months you’ve maintained credit with a lender. The longer, the better. Lenders want to see that you’ve had successful relationships with creditors and those relationships have lasted many years. A history of opening and closing accounts every few months will hurt you. The fact that you will be asked to close all but one credit card could hurt you in this area. However, if the one card you keep has been open for a decade, the impact should be minor. Consider this your “legacy card.” Just make sure it doesn’t have an annual fee. Use it occasionally, pay it off immediately and reap rewards for your credit score.

New Credit

Shopping around for multiple credit accounts is a bad idea. It makes you look desperate for money and unreliable in the eyes of lenders. You want to limit new credit applications, especially when you need to apply for a car or mortgage loan. Joining a debt management program should have no effect on this area of the credit score.

Types of Credit

Think of this category as a place to show how well-rounded you are. If you have a mortgage loan, auto loan, credit cards and you are paying them all on-time every month, this area of your credit score will be well taken care of. Lenders want to see that you have experience with more than just one type of credit. Joining a debt management program should have no impact on this portion of the score.

Don’t Worry About Credit Score Dropping Early

It is true that for the first 8-10 months of a debt management program, your score could take a hit because you close some accounts. It’s also possible you will be pinged with a late payment penalty for a month or two because your credit counselor has negotiated new payment dates with credit card company that don’t match previous dates. This is a temporary blip that should pass after you begin making on-time payments for six consecutive months. Besides, if you’re trying to catch up with bill payments, you probably shouldn’t be out looking for a home or auto loan that will bring your credit score into play.

Impact on Your Credit Score

Enrolling in a debt management program is a long-term decision to eliminate debt so short-term blips on your credit score really aren’t a problem. The typical debt management plan runs for 3-5 years and the long-term gains resulting from eliminating debt far outweigh a temporary negative impact on a credit score.

Ultimately, the best thing you can do for your credit score is improve your ability to make consistent, on-time payments and pay your debt off. Joining a debt management program or speaking with a credit counselor can help you with both areas that make up 65% of your credit score. High marks in both areas will bring high marks on your credit score.

Credit counseling is a free review of your financial situation by a certified financial counselor and will not affect your credit score.

After receiving credit counseling, you may decide to join a debt management program to help you pay off your debts. Many people worry that joining a debt management program will negatively affect their credit.

Debt Management Impact on Credit Score

It’s complicated. Participating in a Debt Management Program can negatively impact your score. It can also have a positive impact.

While InCharge Debt Solutions does not report your participation in its debt management program nor take any action that would affect your credit score, some creditors will report that you are participating and some will show that you have elected to close your account. Closing several cards at the same time can negatively affect your credit score.

To understand how great of an effect closing your accounts can have, let’s examine the four major factors that determine your credit score and see how joining a debt management program may impact them.


SOURCES:

NA, (2013, September 10) Debt Management Plans and Your Credit Report. Retrieved from http://www.experian.com/blogs/ask-experian/debt-management-plans-and-your-credit-report/

NA, ND. A Debt Management Plan: Is It Right for You? Retrieved from http://www.experian.com/blogs/ask-experian/credit-education/debt-management-plan-is-it-right-for-you/