How Does Debt Consolidation Affect My Credit Score?

Reader Question: "Between myself and my spouse, we have a total of 9 credit cards totaling about $7,000 in debt. We are looking to consolidate our credit cards so that we can take care of our debt once and for all. My question- Will debt consolidation affect our credit score negatively at all? We are looking to buy our first home in the next 6 months or so and need all the help we can get as far as our credit score is concerned. We want to spend these next few months lowering our debt-to-income ratio and we believe debt consolidation will help. Some friends of ours joke around and say that consolidating debt is as bad for your credit as filing for bankruptcy is. This isn't true, right?"

Response:

No, it's not true. Consolidating and paying off your debt is practically the exact opposite of filing for bankruptcy. In the first scenario, you are taking proactive steps to pay off your credit card balances 100%. In the second scenario (bankruptcy), you are throwing up your hands and saying, "We are broke and cannot pay you back. Sorry."

Keep in mind there are different ways to consolidate your credit card debt, and they have different affects on your credit score:

Some people go through debt management programs that advise them to settle their outstanding balances -- wherein the credit card company agrees to accept less than the full amount owed. This method is commonly used by people who have fallen behind in their payments, been buried under late fees, etc. Any form of debt settlement will have a negative impact on your credit score, because it shows you cannot handle your financial obligations.

This is different from a debt consolidation loan, which typically pays off the full amount of the credit card balance. A consolidation loan shows that you are proactive about your finances, and that you take responsibility for your own debts. This should have little effect on your credit score, if any.

The one thing that might become an issue is the length of your credit history. As you can see by this FICO score chart, the length of your history accounts for a percentage of your overall score. It's a small percentage, but it's still a factor. If you pay off your credit card balances and the close the actual accounts, you could shorten your credit history in the process. So it might be best to pay the balances off via the debt consolidation, but keep one or two of the accounts open -- ideally the oldest accounts. This will help you maintain the length of your credit history while eliminating the actual debt.

All the same, you should keep tabs on your credit score to see what happens to it. In the off chance that it drops slightly, you will at least be aware of it. And then you can do what's necessary to raise your score before buying a home.

Here's the rule of thumb to keep in mind:

• Anytime you pay your creditors less than what you owe them, it generally has a negative effect on your credit score.
• But when you pay them all of what you owe, it generally has a positive effect on your score.

If you think of this from a mortgage lender's perspective (which is relevant to your home-buying plans), it makes a lot of sense. By consolidating your credit card debts, you will save money by chopping down some of those interest rates. You'll also reduce your debt at the same time, obviously, and this has a positive effect on your debt-to-income ratio. In other words, you can use debt consolidation / reduction to make yourself better qualified for a mortgage loan -- if you go about it the right way.

Here's a similar Q&A session you should check out:
Will debt consolidation help me qualify for a mortgage loan?

And here's an article on BankRate.com that explains debt management programs and how they affect your credit score:
http://www.bankrate.com/brm/green/debt-consolidation/basics4-6a.asp

If you plan to use a debt consolidation loan to pay off your credit card balances, I recommend reading the first article (hyperlinked) and skipping the second.

Hope that helps. Good luck.