Will A Debt Management Program Ruin My Credit Score?
Participating in a debt management program should have a positive impact on your credit score, as long as you are consistent with your monthly payments. The overriding goal of a debt management plan is to get consumers in the habit of paying bills on time every month and reducing the amount owed.
Those two elements – on-time payments and reducing debt – are also the two most critical factors in calculating a credit score, so success in a debt management plan should lead to success in raising your credit score.
On-time payments account for 35% of your credit score in the FICO formula used by most lenders. Amount owed (also referred to as credit utilization) is a close second, making up 30% of the score. Length of credit history (15%), types of credit used (10%) and new credit (10%) are the final components used to calculate a 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 – credit scores can rise 100 points or more – from making on-time payments and eliminating debt far outweigh a brief downturn on a credit score.
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. Consumers in debt management programs do just the opposite. They score well 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 raise your credit score.
Amount Owed/Credit Utilization
This is the second most important category in determining a credit score. Owing money on a credit card is not a bad thing, as long as you pay down the debt every month. That is where many cardholders run into a problem. More than 55% of credit card users carry a balance from month-to-month. About one in five credit card users only pays the minimum. Not paying down the balance has a negative effect on your credit score because it increases your credit utilization.
Credit utilization is a tricky thing because the number of cards you have has a lot to do with how much credit you’re actually using.
Your creditors ask you to close all credit card accounts and that could have a temporary negative affect on your credit score. Credit utilization is the percentage of available credit you use each month. The credit bureaus 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 multiple card accounts could have the opposite effect, though only temporarily because you would steadily be paying down the amount used.
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 amount this month ($3,000), you have used only 20% of your available credit (3,000 ÷ 15,000 = .20). 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 closed, you will not be accumulating any more debt with them. Instead, you are making payments that reduce the amount owed. As your debt decreases, so does your credit utilization percentage.
It’s also worth noting that FICO says that, in some cases, it might include closed accounts with a balance on them when determining utilization.
Why Did My Credit Score Drop After Paying off Debt?
When people ask: Why does paying off debt lower my credit score? They are talking about what happens when you close accounts at the start of a debt management program.
The fact is, it’s a short-term setback that doesn’t amount to much more than a tap on your credit score. Your score can recover quickly. The goal of a debt management program is to pay off your credit card debt. If you stick with the program, over the long run you will see your credit utilization falling into optimal ranges of 30% or less and your credit scoring rising with it.
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.
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.
Debt Management Plans on Your Credit Report
Some creditors may note on your credit report that you are enrolled in a debt management, but that has no effect whatsoever on your credit score. It is a note, just a piece of information for other lenders to consider if they are deciding whether to extend you more credit.
Some lenders read the note as a positive signal that you are addressing your shortcomings and have a plan to eliminate debt problems. Other may see it as a negative because you need help to take care of your debts.
Either way, it will have no effect on your credit score.
Impact DMP Has on 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.
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 and that adversely affects your credit utilization ratio. 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 companies 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.
It’s also worth noting that closing an account will not impact the “credit history” portion of the credit score formula. Even if an account is closed, it remains on your credit history report for as long as 10 years.
The only place you would feel any negative impact is if you were looking for a mortgage or car loan. A lender would have good reason to wonder if someone struggling to pay off credit card debts might struggle even harder with monthly mortgage or auto loan payments.
The solution then, is to enroll in a debt management program and rid yourself of credit card debt. That should rebuild your credit score nicely and make you eligible for the most favorable interest rates on home or automobile loans.
- DeNicola, L. (2019, November 19) How much of your credit should you use? Retrieved from https://www.creditkarma.com/credit-cards/i/how-much-of-your-credit-should-you-use/
- N.A. (ND) A Debt Management Plan: Is It right for You? Retrieved from https://www.experian.com/blogs/ask-experian/credit-education/debt-management-plan-is-it-right-for-you/
- Karl, S. (2018, February 20) Most U.S. cardholders carry at least one balance. Retrieved from https://www.creditcards.com/credit-card-news/credit-cards-by-type-balances-by-credit-tier.php