You may not be old enough to remember a world before credit scores. This is because credit scores were invented in the 1950s. A company that was then known as Fair Isaac Corporation but which is now known just as FICO, created them. It was developed in response to a hue and cry on the part of lenders that were tired of having to read through long, complicated credit reports in order to make a subjective judgment as to a person’s credit worthiness. Credit scoring eliminated this subjectivity and created a sort of level playing field. Wherever a person applied for credit, the lender would be seeing the same credit score.
How your credit score is calculated
Your credit score is a mathematical representation of your credit file or credit report. It’s done using an algorithm that’s known only to FICO. However, we do know that there are five components that are used in calculating your credit score. They are
• Credit history
• Credit usage
• Age of of credit
• Request for credit
• Types of credit
Credit history or how you’ve used credit makes up 35% of your score. If you’ve made all your payments on time, this will help increase your credit score. Credit usage is a short way to describe the amount of credit you have available vs. the amount you’ve used. This is expressed as your debt-to-credit ratio. If you had total credit balances of $20,000 and had charged only $4000 of it your debt-to-credit ratio would be 20%, which would be viewed as a good ratio.
65% of your score
Together, credit history and credit usage makes up 65% of your credit score. The other three components make up only 35%. As you can see from this, how you have used credit and how much credit you’ve used is critical to your credit score.
Debt consolidation and your credit score
Unfortunately, the answer to the question of how debt consolidation will effect your credit score is … it depends. And what it depends on is the type of debt consolidation you choose.
If you were to choose to consolidate your debts by borrowing money to pay them off – which is normally called a debt consolidation loan – this would likely have no effect on your credit score. If you have been making your payments on time and had a decent credit history then borrowing the money to pay off your debts should be neutral. In other words, it should neither increase nor decrease your score.
Consumer credit counseling
A second way to consolidate debts is through consumer credit counseling. If you’re not familiar with this it’s where you go to a credit-counseling agency and it helps you devise a debt management plan or DMP for paying off your debts. The counselor who is assigned to your case will submit your DMP to your creditors for approval. If they sign off on it, you will have consolidated your debts because you will no longer be required to pay your creditors. You will pay the credit-counseling agency instead.
Will this effect your credit score? The credit bureau, Experian, says, “A comment may be added to the accounts in your credit report that are being repaid through a credit counseling program or debt management plan. So, lenders may see that fact. However, that comment won’t affect credit scores.”
A balance transfer
A third way to consolidate debt is by transferring the balances on high interest credit cards to one with either a lower interest rate or a zero interest rate. Although a zero interest rate may seem too good to be true, it really is true. Almost every credit card issuer now has a 0% interest balance transfer card. When you transfer your balances to one of these cards, you would pay no interest for anywhere from 6 to 18 months – depending on the credit card.
This form of debt consolidation may have an effect on your credit score. For example, if you transfer your balances to a new card with a lower limit, this will adversely affect your debt-to-credit ratio. Also, if you apply for a number of these cards, this will increase your requests for credit that, too, will have a negative consequence on your score. Finally, this new card will lower your age of credit, which would also negatively impact your score.
If you’re not familiar with balance transfers, here’s a video that explains what you need to know about them.
Yet another way to manage or consolidate debts is through what’s called debt negotiation or debt settlement. This is where either you or a company you hire negotiates with your creditors to have your debts reduced. Why would any lender agree to debt reduction? It’s because for this to work you must be at least six months behind in your payments. You or the debt settlement company must convince your lenders that it is either settle or see you file for bankruptcy in which case they would get nothing.
This form of debt consolidation would definitely have an effect on your credit score. The experts in this area believe it would drop it by 80 points. This means if you have a credit score of 620, which would be considered “good,” this could drop it to 540, which would be seen by lenders as a “poor” credit score. This could make it more difficult for you to get credit and would certainly increase your interest rates. It could also mean a higher insurance premium and it might even make it more difficult for you to rent an apartment or house.