Does Consolidating Debt Help or Hurt your Credit Score
Table of contents
Ch. 1: Understanding your debt
Ch. 2: Using equity to consolidate debt
Ch. 3: Reorganizing finances
Ch. 4: When to seek debt help
Ch. 5: The bankruptcy option
When Norm Bour was 24, credit was so hard to come by he couldn’t get a gas station company credit card without begging.
While it’s important for you to get a handle on your debt, how you go about it is just as important.
Today, a majority of the home equity lines he approves as owner of Priority Plus Lending will be used to pay off Americans’ credit card debts. Nor is his route the only one to spring up in a capitalistic society: Where there’s a need, there’s a buck to be made, even among the broke.
So you can bet that where competition rules, advertising spin appears. Here are 10 myths about debt consolidation and the truth about them. If you are considering debt-consolidation options, avoid these misrepresentations:
10 debt-consolidation myths
- Credit counseling, debt-management programs — it’s all the same
- Credit counselors can cut your monthly payments in half
- Some companies offer lower interest rates than others
- Some agencies can negotiate lower DMP payments than others
- Debt settlement is the cheapest way to go
- You need a formal program to get out of debt
- Debt consolidation always saves you money
- DMP helps your credit rating
- Bankruptcy will ruin your life
- Bankruptcy is no big deal
1. Credit counseling, debt-management programs — it’s all the same.
Credit counseling involves helping consumers develop a budget and the discipline to make steady payments to clear their debt loads. In a word, it’s education. “Most of these individuals make a decent living, but at the end of the week don’t have enough money and don’t understand why,” says Joel Greenberg, president of New Jersey-based Novadebt.
Debt-management programs — or DMPs as insiders like to shorten it — are one tool in the credit counselors’ kit. Basically, the DMP plays policeman, taking your monthly lump-sum payment and distributing it to your creditors until the accounts stand at zero. They then close those accounts. According to Greenberg, less than 35 percent of the people who call consumer credit counseling agencies truly can benefit from a DMP.
2. Credit counselors can cut your monthly payments in half.
No such luck. This is a numbers fudging claim that holds true only in the narrowest of circumstances. For instance, if you miss two $200 payments on a $10,000 balance, the third month’s bill will make it $600 that you owe. DMP personnel re-age that bill, knocking your payment amount back to $200. You haven’t escaped anything — the missing money was merely tacked back onto the total owed.
And most folks who walk through his doors haven’t missed payments, says Greenberg. These harried souls will see a bit of relief from an interest reduction, but by no means will they magically owe only half their bills.
3. Some companies offer lower interest rates than others.
It drives Richard Musci, chief lending products officer at Schwab Bank, crazy to see teaser ads for low interest rates on home equity lines. Any quotes that fall within prime minus 75 basis points to prime plus 2 percent are reserved for those who make the A credit list. Those lower down the credit spectrum can expect to strike deals for prime plus 4 percent or 5 percent, not to mention a point or two in fees.
“They’re using it to get people in and take them so far down the road that by the time they sign the loan papers, they’re committed. They don’t want to start all over again,” he says. It also serves a second devious purpose: lower advertised rates push these companies to the top of the search engine lists.
But just how low is too good to be true? Bour’s rule of thumb: If 90 percent of the lenders are advertising a 5.75 percentage rate, the lone shark waving even a 5.25 should send up a red flag. “But it doesn’t because people always think they’re smart enough to find the deal no one else has,” he says.
4. Some agencies can negotiate lower DMP payments than others.
That would be true if these debt-management programs involved negotiation. They don’t. A majority of creditors have existing programs where they automatically shuffle off 95 percent of individuals enrolled in a DMP, says Greenberg.
If a counselor indicates differently, you are in the clutches of a debt-settlement program. This version accepts your monthly lump-sum payments, but holds that money until creditors scream. At that point, the debt-settlement personnel negotiate to repay cents on the dollar. Your credit rating gets maimed in the process.
5. Debt settlement is the cheapest way to go.
Greenberg urges anyone introduced to a debt-settlement program to run hard in the opposite direction. “First of all, it’s unethical,” he says. “It’s just wrong to make payments on an account and have the money sit in someone else’s pockets until the creditor gives up on the collection calls.” The real skunks insert a clause in the contract that says if you miss a payment to the debt-settlement company, it keeps all the money in the ante as a fee.
Secondly, this route dings your credit history severely, as all those “pay us now” letters count against you, not the company. Finally, the amount the creditors forgive in the end is considered income for you, and you owe taxes on that amount. “If you’re going to take this route, you might as well declare bankruptcy,” Greenberg says.
6. You need a formal program to get out of debt.
Many creditors will enroll you in their special reduced-interest programs if you approach them as an individual. The pain comes in making all those phone calls and knowing what to ask for.
Home equity lines don’t require third-party guidance, nor does refinancing your first mortgage to get your hands on a lump sum of cash. On the flip side, these options still require spending discipline on your end lest you wind up with a mortgage payment, home equity line invoice and another $10,000 credit card debt six months down the road. This time, your house is on the line.
7. Debt consolidation always saves you money.
Better ask a calculator to determine the truth of this statement for your situation. For example, if a lender assures you it can secure financing with no out-of-pocket costs, that doesn’t mean it’s a kinder, gentler source of funds. It’s code for “We’re rolling our fees into your loan, where they are also subject to the interest rate.”
The truly unfortunate fall victim to flipping — a process that ruined one of Musci’s elderly clients. A lender offers a debt-consolidation loan plus cash out, with no out-of-pocket fees. A year later, it calls again to say that since your home has appreciated, could you use more cash? Say yes, and they again sock you with fees hidden into those monthly payments. This cycle continues until you break.
“The consumer thinks this person is taking care of them. But in my client’s case, the company ran up $15,000 in fees, and put her at 100 percent loan-to-value,” says Musci. “She eventually had to sell her house to get out from underneath it.”
Deciding on debt consolidation is a simple formula for Greenberg: Compare your existing minimum payments to what your payments will be for that same debt under the DMP, including fees and voluntary contributions. If the latter doesn’t save you 5 percent to 10 percent, it’s the wrong choice.
8. DMP helps your credit rating.
The second question Greenberg asks before signing with a DMP: Is your credit rating pristine? If you’ve managed to pay your bills on time to this point, know that this step will muck up your credit history. The home equity line might make more sense here, Musci says.
On the other hand, if you’ve missed payments and it already shows on your report, credit counseling won’t make it worse. That’s when a DMP can improve some situations, as creditors sometimes applaud that you’re finally taking steps to handle debt appropriately.
9. Bankruptcy will ruin your life.
A good credit counselor will level with you when your situation requires this final stroke. “I’ve had people with no other alternative — they’ve spent years borrowing from every relative just to make ends meet. They’re on a fixed income, usually elderly,” Greenberg says. “Having to deal with bankruptcy in their background is a better alternative than going without food and shelter.”
10. Bankruptcy is no big deal.
Bour has talked to an amazing number of people in their 20s who filed bankruptcy for a $7,000 debt. “It’s ridiculous because the damage will linger long after whatever the $7,000 debt was for,” he says. Bankruptcy is an extreme solution, reserved for cases like someone on a $20,000 annual salary with a cumulative credit card debt of $50,000 or more.
If you file Chapter 7 — exoneration of all debt — the window is nearly 10 years. With Chapter 13 — reorganization of debt — that seven-year clock starts ticking after you pay off the debt. So if you need five years to get back on your feet, assume this cloud follows you for 12 years.
Employers look at credit reports, and occasionally refuse to hire based on what they find. If you deny bankruptcy on many forms, you can be held accountable later for lying on an application. Insurance companies can deny coverage as well.
In the end, debt management resembles weight loss: No one can do it for you, and the process takes four to five years on average. “There’s no panacea,” says Greenberg. “You have to buy into the process and really work to reach the goal.”