The facts behind debt reduction methods

Speaking of Credit columnist Barry Paperno
Barry Paperno is a freelance writer and credit scoring expert with decades of consumer credit industry experience, serving as consumer affairs manager for FICO (formerly Fair Isaac Corp.) and consumer operations manager for Experian. He writes "Speaking of Credit," a weekly reader Q&A column about credit scoring and rebuilding credit, for His writings about credit scoring have appeared in The Huffington Post, MSN Money, CBS Money Watch and other consumer finance websites.

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Question for the expert

Dear Speaking of Credit,
A friend and I got into an argument over just how debt reconsolidation or debt settlement can affect your credit score. My friend states that while debt reconsolidation/debt settlement can help you resolve your credit card or credit problems, you may as well say that you have filed bankruptcy, as this will cause the words "debt counseling" to appear on your credit report and that will make it impossible to borrow money at a bank.

Then my friend went on to say that while these credit card reconsolidation companies can help you get out of debt, it is just like filing bankruptcy and that while they tell you some things, there are still things that they don't tell you. I have been through debt settlement before back in 2001, and nothing like "debt counseling" has ever appeared on my credit score. Could you perhaps explain this so that I can understand it? Thanks. -- Kelly

Answer for the expert

Dear Kelly,
The questions you raise about the three most popular approaches to debt resolution -- debt consolidation loans and credit cards, consumer counseling debt management plans and debt settlement agreements -- do a great job of clearly illustrating how confusing the credit scoring impacts of these debt solutions can be. And because the decision you make can affect your ability to obtain future credit and obtain it at an affordable cost, you're doing right by asking for help.

The following are some important facts surrounding the credit scoring implications of these three common debt reduction options:

Debt consolidation. Typically requiring either a new loan or credit card, debt consolidation consists of paying off multiple debts with the proceeds from a new installment loan or using a balance transfer card to move existing balances to a single credit card, with the result being a lower overall monthly payment and, when possible, a lower interest rate.

Not every debtor qualifies. Balance transfer cards and consolidation loans typically cater to consumers who have managed to maintain decent credit scores, despite high debt, by faithfully making minimum payments each month and holding on to credit limits that are high enough to avoid dangerously high credit utilization (card balance/limit ratio). Also available to indebted consumers with good credit scores are low introductory fees and rates on credit card balance transfers.

Of these two types of consolidation vehicles, the best strategy for raising your score while trying to get out of debt is moving revolving debt into a consolidation installment-type loan. Credit scores consider installment as less risky -- and therefore less harmful to the score -- than revolving debt.

A major benefit of both card and loan consolidation is that as long as minimum payments are made on time each month, neither causes any negative credit scoring impact from the often-used "debt consolidation" credit reporting notation attached to such accounts.

Debt management plan (DMP). Typically administered by consumer counseling agencies, debt management plans rely on cooperation from creditors to accept lower monthly payments, often at a lower rate of interest over a period of three to five years, until the debt is paid off. With a DMP, the consumer makes one monthly payment to the counseling agency, which disburses payments to the various creditors.

One of the unique pluses of DMPs is that by requiring credit counseling and budgeting as part of the program, they provide consumers with the financial management tools to keep future spending under control.

Also a plus: The credit reporting notation attached to accounts included in a DMP, "consumer counseling account," carries no negative impact on credit scores as long as all payments are made on time. And upon completion of the plan, these accounts are reported positively as "paid in full."

Debt settlement. The consolidation methods above eventually require paying all debts in full. Debt settlements are different. In a debt settlement, the creditor agrees to accept less than the full amount due to avoid having to employ a collection agency or take legal measures to resolve the debt. Consumers can settle debts themselves, or hire a debt settlement company to do the work for them.

There are two downsides to paying less than the total amount due as part of a debt settlement:

1. Debt reduction is often considered taxable by the IRS, and if the amount of forgiven debt is $600 or more, the consumer will receive an IRS form 1099-C for that tax year. That form flags the IRS that taxes may be due on the forgiven debt.

2. After payoff, the account is likely to appear on the credit report with the notation, "settled for less than the full amount due" -- a derogatory credit scoring mark carrying a scoring impact similar to that of a charge-off or other indicator of default. That notation stays on your record for seven years.

To summarize, while considering the various debt reduction programs available to financially troubled consumers, don't enter into any debt resolution plan without fully understanding the potential impacts to your credit score during and after completion of the program. Your decision could seriously impact your ability to qualify for affordable credit for years to come.

See related: Partial payment agreements can hurt your credit score, Choosing a debt management program, 6 debt consolidation traps and how to avoid them

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Updated: 01-20-2018