Vision Credit Education, Inc.

There are two primary purposes for credit counseling. One is to improve your financial condition. The other is to improve your credit. So how exactly is your credit affected by credit counseling?

First of all, it is important to recognize that credit counseling is a process for evaluating your credit and financial needs, examining your options and developing an action plan. A debt management program is just one tool that may be used in an action plan, but it is this option that most people think of when they hear “credit counseling.”

The Myth

It is still common to hear bankers and mortgage brokers that still believe that a debt management program is detrimental to your credit. They are citing a penalty that was assessed prior to a 1999 study by Fair Isaac Corporation.

Prior to 1999, simply joining a debt management program would lower your credit score. However, Fair Isaac Corporation completed a comprehensive study to determine the nature of risk posed by consumers on a debt management program. The previous assumption was that people were on a debt management program because they failed to manage their money and their credit.

Results of the Study

Fair Isaac concluded from the study that a client on a debt management program was no more likely to default on their debt than a consumer that did not enroll. This is a powerful statement, considering that most people previously believed that debt management programs were designed for people that mismanaged their finances.

As a result of the study, Fair Isaac Corporation removed the penalty from the credit scoring formulas that previously existed when a consumer joined a debt management program. After all, the evidence supported the fact that indebted consumers that were serious about restoring their finances and their credit actively pursued credit counseling, while others that posed a high default risk tried to hide from their problems.

There is no penalty for joining a debt management program, and your credit score does not change because of your participation in credit counseling. An included creditor has an option to reflect your participation in credit counseling on your credit report. However, any mark is a text notation that is not factored into your credit score.

So Can Credit Scores Change Due to Credit Counseling?

Yes, your credit scores can and likely will change due to credit counseling. There are shorter term and longer term effects that will cause most participants’ credit scores to change as a result of a debt management program.

First of all, part of your credit score depends on the length of time that you have maintained a credit account. Joining a debt management program means that your credit accounts will be inactivated. They will still appear on your credit report, your payments posting to those accounts will still be reflected, and they will still be factored into the credit score calculation. Since the accounts are no longer active, any lengthy account history that you had will gradually have less impact on your credit score.

For older accounts, the impact could be more, such as if you had a major credit card account open for many years. For accounts that you have had open for less than 2-3 years, the impact is negligible since the accounts are not considered to be seasoned.

Another effect is your credit utilization rate. This is a determination of the percentage of unsecured credit that you are using. If you are using only 40% of your available credit on an account, then joining a debt management plan may cause a small drop in your score for the first few months. The reason is that by inactivating the account, you would lose the available credit that is calculated into your credit score.

We have found that most clients that contact us, however have used much higher proportions of their total credit lines. It is normal for consumers to contact a credit counseling organization for help only after they have used most of their available credit. If you are using more than 80% of your total credit limits, then it is unlikely that your score would be affected negatively at all by joining a debt management program. Your score likely will have already suffered tremendously due to your high balances and high credit utilization rate.

There are other effects on your credit scores due to debt management program participation. Your current payment history will improve your credit scores throughout the program. Your payment history comprises 35% of your credit score. By continuing to demonstrate a history of on-time payments, your credit scores will improve while you are proceeding through debt management.

Additionally, your debt balances will drop, and likely much faster than you could do on your own even with some additional income. As these balances are reduced, your credit scores will also increase. Your debt balances can influence 30% of the credit scoring formula.

As you can see, roughly 2/3 of your credit score depends on factors that a debt management program specifically helps to improve. As long as you don’t open any new accounts while enrolled, then that positive impact increases to 75% of the credit scoring formula.

The result is that some clients normally see a small drop in their credit score within the first few months of their debt management program. However, their credit scores then begin a gradual increase. Many see their credit scores back to where they started within the first 6-12 months. By the time they complete their debt management program, their credit scores are far higher than when they began.

Understand the Influence

Most people that need debt management assistance that are hesitant to enroll are concerned that they either will not have use of their credit cards for emergencies, or that they will be unable to make a major purchase on credit, such as a car or home loan. These are valid concerns.

However, most will not be able to use credit cards for emergencies due to a lack of available credit. Additionally, many loan requests will be denied due to the high debt balances that are listed on their credit reports. If they are approved, the cost of the loan will be so high that it is not worth the expense.

For clients that undergo credit counseling and also enroll in a debt management program, their ability to qualify for such loans will increase tremendously once they have expanded their payment history and reduced their debt balances.

Waiting 3 or 4 years to buy a home can save tens of thousands of dollars in interest if it means that you qualify for a better interest rate. Driving that same used car for another year or so can also save you money while you save for a replacement. You will likely qualify for a much better rate if you have repaid a fair amount of your debt prior to submitting an application for a loan.

Remember that credit counseling is a process for providing options as a means for improving your financial situation. The result of credit counseling is a greater understanding of how your credit has been affected by your decisions and a well-designed action plan for you to achieve your goals.

If you have struggled with debt, it may be a sign that credit counseling is for you. Depending on your resources and expenses, you may be able to utilize specific strategies for debt repayment. Credit counseling can help you develop self-guided approaches that you can implement on your own to restore your financial situation. If you need to enroll in a debt management program, you can benefit from reduced interest, reduced payments and relief from fees so that you can eliminate your debt and improve your credit much faster than you might be able to do on your own.

Taking control of your finances now can help you improve your credit, eliminate future debt payments, lower the cost of credit and improve your net worth. For more information about credit counseling and credit, contact the Federal Trade Commission, the Better Business Bureau, or you may contact one of our Accredited Financial Counselors with your questions.