The following is presented for informational purposes only.
If you’re looking for a way to get debt free, you may be considering consolidating your debts, trying to settle with your creditors, or getting on a debt management plan. It can be important to understand and compare your options, because they could affect your finances and credit in different ways.
Consolidating your debts
There are many ways to consolidate your debts, but generally they all involve taking out a new credit account and paying off your existing balances. Doing so can simplify your finances as you’ll have fewer monthly bills to manage. You may also be able to save money if your new account has a lower interest rate than the debts you’re consolidating.
If you own a home, you may be able to take out a home equity loan or use a cash-out refinance to consolidate your debts. Taking out a personal loan could also be an option. Although personal loans may have a higher interest rate than home loans, you take on less risk since you don’t need to put up collateral. You also might be able to transfer debts to a credit card that has a zero percent promotional annual percentage rate (APR) on balance transfers, which could save you a lot of money as you pay down the balance.
Tommy Lee, a principal scientist at FICO®, says, “Consolidating debts may or may not help one’s FICO® Score, depending on how the debt is consolidated and what actions are taken afterward.” Lee points to the “amounts owed” credit-scoring factor, which makes up about 30 percent of your FICO® credit score. “Key measures in the ‘amounts owed’ category include utilization ratios, as well as the total dollar amount of debt owed,” says Lee.
Your utilization ratios are the percentage of available credit on revolving credit accounts (e.g. credit cards or lines of credit) that you’re currently using. Your ratios on individual accounts can impact your scores, but your overall utilization ratio may be more important to your scores. In either case, having a lower utilization rate is better.
If you take out an installment loan, such as a personal loan, and pay off revolving debts, you can quickly decrease your utilization ratios which could help your scores. Opening a new credit card and transferring the balances could also help because you’re increasing your available credit by opening the card. However, you’re not decreasing your overall utilization as much because the new credit card is still considering in the utilization calculations.
No matter which consolidation option you use, you’ll want to try and avoid falling deeper into debt after consolidating. Paying off your credit cards with a personal loan could backfire if you end up maxing out your newly available credit limits. If you think this could happen, you may want to close your cards after consolidating. It may not be ideal for your credit scores, as your utilization rate could increase, but it might be the right move for your finances.
Settling your debts with creditors
When you settle debts, you’re offering to pay your creditors less than the full amount you owe. It may sound like a good option, but you have to be careful because trying to settle your debts can hurt your credit and may actually wind up costing you more overall.
Creditors generally won’t agree to a debt settlement agreement unless you’ve shown you’re unable or unwilling to pay the full balance. Knowing this, debt settlement companies may suggest you stop making payments altogether.
However, Lee says, “Payment history is the most important category in a FICO® Score, consisting of about 35 percent of the FICO® Score calculation.” Late payments can hurt your scores, and the impact can increase the further behind you fall on your payments.
There’s no guarantee that the creditor will agree to settle your accounts. The creditors may charge you late payment fees, and your account may continue to accrue interest while you’re not making payments. But in the end, the creditor may decide to sue you for the debt rather than settle.
Also, a settled account indicates you didn’t fully repay your loan. “Therefore, settling a debt for less than the full amount owed could hurt one’s FICO® Score,” says Lee. He says the impact may be less harmful than paying nothing and having the account sent to collections or defaulting, but it could still lower your scores.
Signing up for a debt management plan
Credit counseling organizations may offer a debt management plan (DMP) as a path to paying off your unsecured debts, such as credit cards or personal loans.
When you sign up for a DMP, the organization will act as a middle-man and negotiate on your behalf. It may be able to get your creditors to decrease the interest rates on your accounts, waive fees, or lower your monthly payment amount. A DMP can also simplify your bills because you’ll make one monthly payment to the organization, which will then pay your creditors on your behalf.
“The FICO® Score ignores any mention of credit counseling or debt management plans on your credit report,” says Lee. “It also won’t hurt your FICO® Score if your credit report includes one or more accounts described as being paid through a credit counseling agency or a debt counseling agency.” However, he did note that your scores could still be affected if the organization is late making payments.
When you complete the DMP, your balances may be paid in full which can be better for your credit than settling the debts. However, you may be required to close your credit accounts while you’re on the DMP. Your credit scores could drop as a result, although they are very likely to recover as you continue to make on-time payments and decrease your balances.
One downside to DMPs is that you can’t include student loans or secured loans, such as a mortgage or auto loans. The organization managing your DMP may also charge a monthly fee, and you may want to compare your options before signing up.
Which option is best?
There isn’t a clear winner as everyone’s situation is different. However, knowing your options and how they could affect your finances and credit could help you determine what’s best for you.
If you’re comparing consolidation and DMPs, want to learn more about debt settlement, think bankruptcy might be a better route, or simply want to talk over your options, Money Management International offers free sessions with our trained credit counselors.