Debt Relief Options and Their Impact on Your Credit Score

The word ‘debt’ generally tends to make people uncomfortable. It is quite understandable since debt entails financial as well as social trauma. What’s the best way to get out of debt? There no one easy or simple answer. People always tend to think that they can get out of debt easily without damaging their credit score to the point that it becomes a burden.

Most consumers are ignorant of the fact that although the FICO score is directly reflective of an individual’s debt and credit usage conditions, only a third of the score is actually calculated on the basis of the individual’s debt load. Here we analyze some of the basic methods of getting out of debt and how they impact your credit score.

Debt consolidation

In this particular case, a debtor applies for a consolidation loan and uses it in turn to pay off multiple debts. The debt consolidation loan itself carries a fixed low interest rate which makes it easier for the debtor to repay the loan.

Monthly payments are also reduced through consolidation and therefore debtors are less likely to be late with their payments. This is turn would mean that debtors would have a better shot at staying current with their payments and their credit score would recover pretty fast in case they had fallen behind on their payments previously.

Most people tend to take out a consolidation loan to pay off their credit card bills. In this particular situation, using a consolidation loan to settle the accounts could have a negative or a positive impact on your credit score. Paying off the balance on a credit card account will free up more credit and in turn boost your credit utilization ratio. This would directly improve your credit score.

On the other hand, the consolidation loan you used to pay off the card will appear on your credit report and FICO will consider this to be a risk factor which could mean that your credit score might go down. The best option you have is to use a loan against your retirement account to pay outstanding bills. Retirement account loans are not reported to the credit bureau and hence doesn’t affect your credit score.

Debt snowball and avalanche

These are two of the best ways to handle your debts and it has no negative impact on your credit score whatsoever. The avalanche method involves paying off the largest and highest interest loan first and slowly moving down to paying the smallest loan with the least rate of interest at the very end.

The snowball method is the exact opposite where you start paying the lowest interest smallest loan first and move towards the larger loans with higher interest rates. There is very little difference between the two methods from a financial standpoint but each offer different psychological advantages suited for debtors with different mentalities.

Credit counseling and debt management

Consulting a qualified credit counselor has many advantages. You can actually get some professional insight into your debt problem and an overview of how to tackle it. There are even online credit counseling services offered by different companies.

Consulting a counselor has no effect on your credit score whatsoever but enrolling in debt management programs offered by credit counseling agencies will often have a moderate but negative impact on your credit score.

When you enroll yourself in a debt management program, your credit card accounts are automatically shut down which alters your credit utilization ratio. This in turn would damage your credit score. On the other hand, when you are enrolled in the program, you just need to make one single payment to the credit counseling agency which is then disbursed among your creditors.

Your creditors may also choose to re-age the account and bring it up to ‘current’ status after receiving a certain number of timely payments. This basically means that your score will improve as long as you pay on time.

As far as FICO is concerned, they dont take DMPs into consideration when they are calculating your credit score. The fact that you are paying your debts through a DMP will appear on your credit report and individual lenders might take note of this.