How debt management plans affect your credit

Opening Credits columnist Eric Sandberg
Erica Sandberg is a prominent personal finance authority and author of "Expecting Money: The Essential Financial Plan for New and Growing Families." She writes "Opening Credits," a weekly reader Q&A column about issues for people who are new to credit, for

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Dear Opening Credits,
I am in credit card debt for a substantial amount; I am thinking of using a debt management company who will take over my payments, but I will be paying them, cause that debt management company can get my finance charges way down. Will this cause a negative notation on my credit? I just wanted to know the negative impact on my credit. Thank you. -- Norma


Dear Norma,
Kudos on taking the initial step toward bringing your consumer debt under control! Just making an appointment at a credit counseling agency is a move in the right direction. And it appears you've already had the budget and debt counseling session, since you seem to know how their primary program works. These agencies refer to it as a debt management plan (DMP). If you choose to participate, the effect on your credit report would totally depend on what it looks like today.

To review: If you choose to enter into a DMP, the first thing you would need to do is close any active cards included on the plan. That action would prevent you from charging more and adding to the balances. The counselor should have informed you about what the monthly payment would be -- a figure calculated to delete the total debt in three to five years. Instead of you paying each credit card company individually, the agency takes over. You send them one payment per month, and the agency then distributes the funds to those you owe. Many credit issuers reduce interest rates to plan participants, which is a major economic incentive for you, the consumer. This way more of your money will go toward the principal rather than finance fees.

It is normal to be nervous about the DMP's credit reporting impact. As a former counselor, I used to hear these fears all the time. "But will this hurt my credit score?" asked those deep in debt, behind on payments, and fielding frightening collection calls. My response was almost invariably, "You have far more pressing problems to think about right now. Besides, you don't have a credit score worth preserving -- it's so bad that it can only get better!"

And this might be true for you, too. If you have been paying your creditors late or some of your accounts have been sent to collections, your FICO score (the credit score most widely used) has already taken a beating. Payment history is the most important scoring factor, and the second most important factor is what you owe compared to how much you can borrow.

To answer your question, then, if your credit report is showing a file full of late payments and you're carrying an overabundance of debt, a DMP will probably improve your credit rating. Because these third-party organizations deduct the payment from a checking account once a month, they ensure that creditors receive monies when they should. That will prompt the creditors to send that positive payment activity to the credit reporting bureaus. In time, your previously spotty payment history will be overshadowed by the perfect one. More, the total of your financial obligations will steadily decline. You would satisfy the two most weighty FICO scoring factors, so if your numbers were low, they will rise.

On the other hand, if you've been paying on time and the amount you owe is a small fraction of what you can contractually borrow, your credit scores are probably in fine shape. In that case, a credit counseling agency's plan might hurt your scores, because you would be taking well-managed accounts out of circulation by closing them. Most people who seek help, though, are not in this situation. By the time they meet with a counselor, their credit scores are usually on the low end of the scale, so will usually go up.

Mind that scores aren't the only credit reporting concern. The credit counseling agencies do not send information to the credit bureaus, but the credit card companies do. They can also specify that your account is being administered by a third-party organization. That notation is not a credit scoring factor, but if another lender sees it on your file, they are free to make a judgment about it and you. Some will consider it negative since it's proof that you needed help, while others may believe it's a good sign, because you're taking the responsible action -- paying your creditors in full.

See related: Choosing a debt management plan

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Updated: 01-20-2018