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We’ve discussed different ways to consolidate your credit card debt — called “debt consolidation” — and also how to take advantage of debt settlement in past articles here at CreditShout. But what are the real differences between the two processes? And how does each affect your credit score?
Debt Consolidation and Your Credit Score
When you perform a debt consolidation on your own, by transferring debts onto one lower interest credit card, your FICO credit score won’t be affected at all.
If you applied for, and received, a new card in order to perform the credit card consolidation, your score will take a slight hit for the next six months.
First you’ll lose 3 to 5 points for a credit inquiry, sometimes called a “hard pull.” Then you’ll lose another 5 to 10 for having opened a new account.
New accounts are considered “high risk” to lenders, since it’s more likely people will forget to make a payment. If you open several new accounts at once, it could indicate financial difficulties, a big red flag to lenders.
If you pay balance transfer fees when you consolidate your credit card debt, your debt-to-available credit ratio will rise, too, adversely affecting your credit score.
Expect the same slight effect on your credit score if you consolidate your credit with a personal loan or a home equity loan.
To minimize the adverse effects of debt consolidation on your credit score, keep your old accounts open after you consolidate your credit card debt. This way, as your debt decreases, your debt-to-available credit ratio will drop. This can significantly raise your credit score.
Just be certain not to use your credit cards that now have a zero balance.
When you go through a debt consolidation company or credit counseling agency for your debt consolidation, this gets reported to the credit reporting agencies. This sends the signal that you can’t manage debt on your own, and need professional help.
Since this can significantly affect your credit rating, look to this as a last resort before bankruptcy.
Understanding Debt Settlement
Debt settlement is a bit of a different animal, although it sometimes involves debt consolidation after you settle with your creditors at the lowest interest rates and lowest payment amounts possible.
You can call each of your creditors individually and negotiate a debt settlement, usually only after you are in default by 90 days or more. Similarly, most debt settlement agencies will only help you after you are in default on your debts and owe more than $10,000 in credit card debt.
When you negotiate a debt settlement — or hire a company to do it for you — your debt is negotiated down to a fraction of what you owe, sometimes as little as 50% of the original debt.
When these debts are finally paid off, it’s listed as “Settled,” not “Paid in full.” This is a black mark on your credit reports and a big minus to your FICO credit scores.
Additionally, the fact that you can’t even consider debt settlement until your accounts are in default means that, by this point, your credit score has already been hit pretty hard.
Will the loss of a few more points put you in the “poor” category, where it will be harder to get new credit, rent an apartment or find a job ? Some sources say debt settlement is nearly as bad as a bankruptcy on your credit report.
Many times, debt settlement agencies collect monthly payments from you, (which include the company’s fees) without making payments to your creditors for several months. Each time you miss a payment, your credit score drops.
If you are in debt and can’t see a way out, consider credit counseling to find a better way to pay off your debts before undergoing debt settlement. (Use this link from the Department of Justice to find approved credit counselors in your state.)
Debt settlement can save you money, but may cost you in the long run.
Additionally, any debts forgiven through a debt settlement arrangement may count as taxable income. You won’t owe money to credit card companies, but you may have to pay a large bill to the IRS after your debt settlement.
Those ads promising a “bail out” sound enticing, and it may seem appealing to cut your credit card bills in half. But the long-term ramifications aren’t worth it.
Instead, consider consolidating your debt into a lower-interest loan or credit card, making timely monthly payments that are as large as you can manage, and set goals to see yourself debt free after time.