Debt Relief Experts
Your credit score reflects your credit history and how you manage your debt obligations. Any action you take to address debt problems – whether making late payments, closing credit accounts, or restructuring debt – will impact your credit rating. Different debt relief programs offer various paths to alleviate debt but can affect your credit score in distinct ways. Credit bureaus track these changes, and lenders use this information to evaluate your creditworthiness. This article explores each program’s effect on your credit history and provides advice on how to rebuild your score while addressing debt.
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Types of Debt Relief Programs
There are multiple debt relief options available, each with unique benefits and potential impacts on your credit score:
- Debt Consolidation
- Debt Settlement
- Credit Counselling
- Consumer Proposal
- Bankruptcy
Each option affects your credit score differently, but all reflect the reality that you’re taking action to resolve your debt problems. While considering these impacts is important, remember that credit scores can be rebuilt, and the long-term benefit of becoming debt-free often outweighs temporary credit concerns.
Debt Consolidation and Your Credit Score
Debt consolidation combines multiple debts into a single new loan, typically offering lower interest rates and simplified monthly payments. This traditional banking solution works best if you qualify for a lower interest rate and can maintain regular repayment. However, if you currently have bad credit, you may not qualify for favourable rates.
Debt consolidation can cause a temporary drop in your credit score:
- A hard credit check is recorded on your credit report when you apply for a consolidation loan, typically lowering your score by 5-10 points
- Opening a new credit account reduces your average credit history length
- Your debt consolidation lender may require you to close credit card accounts, which can increase your credit utilization ratio, and your mix of credit types could decrease.
- Multiple loan applications in a short period (if shopping for the best rate) can result in several hard inquiries.
Longer term, debt consolidation can positively impact your credit score:
- Your credit utilization ratio improves as credit card balances are paid off.
- Making regular payments on your consolidation loan builds a positive payment history.
- Debt consolidation may improve your credit mix if you previously only had credit cards or other revolving lines of credit.
- Having one payment instead of many reduces the risk of missed payments.
Assuming you make all consolidation loan payments on time, it can take six to twelve months for credit scores to improve after a new debt consolidation loan. After 12 months, significant improvement is possible if payments remain current and credit card balances stay low. Consider keeping one credit card active with a small recurring payment to maintain the account but keep balances below 30%.
Missed payments and taking on new credit card debt while paying off a consolidation loan will harm your credit score. This is why it is important to ensure you can afford your debt consolidation loan payments.
Credit Scores and Settling Debts with a Debt Collector
Debt settlement involves negotiating with creditors to pay less than the full debt amount owed, often in a lump sum. If you’re considering settling debts with a debt collector, your credit report likely already contains negative information, including late payments and accounts in collection.
When you settle debts with a debt collector:
- The account may be marked as “settled” or “settled for less than full balance”.
- Your credit report will show a zero balance for the account you settled.
- Any R9 rating (debt in collections) remains for 6 years.
- Any prior late payments or defaults also remain for 6 years from the date of default.
It’s important to understand that paying a collection account doesn’t remove this negative history. Debt collectors cannot and should not promise to remove accurate negative information from your credit report in exchange for payment. This practice, sometimes called “pay for delete,” isn’t permitted by credit reporting rules in Canada.
Credit Counselling and Credit Score Impact
Credit counselling involves working with a credit counselling agency to set up a debt management plan (DMP) that consolidates your debt payments without a loan. A credit counsellor assesses your financial situation and negotiates with creditors on your behalf while providing budgeting guidance and financial education.
There is a misconception that credit counselling, or a debt management plan (DMP), will not affect your credit score. In fact, it will.
Entering a debt management plan through credit counselling will be reported on your credit report as follows:
- Accounts included in the program are marked with an R7 credit rating
- A note that you are making payments through a third-party arrangement (DMP) will remain on your report for 2 to 3 years after you pay off your debts.
- Each debt included in your debt management plan will be marked as part of a registered repayment plan.
- The individual debt will remain on your credit report for 6-7 years from the date of default.
- Your credit limit on existing accounts may be frozen during the program.
While this impacts your credit score initially, there are benefits to a debt management plan. Interest charges are often reduced or eliminated, you receive structured support to repay your debts, and regular payments help establish better financial habits.
However, it is important to understand that a DMP through credit counselling has the same impact on your credit as a consumer proposal, yet it is much more costly. High monthly payments are the main reason why debt management programs fail.
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Consumer Proposals and Your Credit Score
A consumer proposal is a legal arrangement where you offer to pay a portion of what you owe, with payments spread over up to 5 years. As a legal proceeding, it provides protection from creditors and stops interest charges completely.
A consumer proposal is reported on your credit report as follows:
- Accounts included in the program are marked with an R7 credit rating
- A note that you in a consumer proposal will remain on your report the earlier of six years from filing or 3 years after completion
- Each debt included in your proposal will be marked as part of a consumer proposal.
- The individual debt will be cleared 6-7 years after the date of default
- You will be required to surrender existing credit cards
In other words, both a consumer proposal and a debt management plan have the same impact on your credit report. There is no difference in how these debt programs are reported and when the notice is removed.
While a consumer proposal does impact your credit score, it also provides debt relief. You pay back less than you owe, and monthly payments are more affordable than through credit counselling. As a result, it is often easier to pay off your proposal early. That means that the proposal will be removed from your credit report sooner.
Bankruptcy and Credit Score Impact
Personal bankruptcy, often considered a last resort, is a legal process that eliminates most unsecured debts, offering a fresh financial start. While it has the most significant negative impact on credit, it’s often the shortest path to debt freedom, typically lasting 9 to 21 months.
Here is how bankruptcy appears on your credit report:
- A bankruptcy is listed as an R9 credit rating.
- First time bankruptcy, no surplus income: 9 months + 7 years = just under 8 years
- First time bankruptcy with surplus income: 21 months + 7 years = just under 9 years
It’s important to understand that the impact of bankruptcy on your credit isn’t permanent. Credit rebuilding can start immediately after discharge, and many clients achieve good credit scores within 2-3 years post-discharge.
Rebuilding Credit After Debt Relief
Rebuilding credit after any debt relief program follows similar principles. While credit repair companies may make promises, the most effective approach involves:
- Obtain a secured credit card and use it responsibly
- Make all payments on time, every time
- Keep credit utilization low (under 30% of available credit)
- Monitor your credit report regularly
The key is starting these habits as soon as possible, even while completing your chosen debt relief program. Even with a consumer proposal, many clients find their credit scores improve significantly within 2-3 years of completing their program.
How to Choose the Best Debt Relief Program
When struggling with debt, many people focus on maintaining their credit score rather than addressing their financial problems. However, while making minimum payments on high-interest debt can preserve your credit score, it can also cost thousands of dollars in interest charges – money that could be better used to rebuild your financial future.
When choosing a debt relief option, consider your current debt level, income stability, and credit goals. Debt relief options like consumer proposals or bankruptcy might temporarily impact your credit score but can significantly reduce or eliminate your debt, freeing up money for savings and necessary expenses.
Choosing a debt relief program is about getting out of debt in the best possible way. While the impact on your credit history may worry you, the determining factor should be which program makes the most sense for you financially.
As Licensed Insolvency Trustees, we can provide a complete assessment of your situation and explain the cost and impact of all available options, so you have the information to make an informed decision. Contact Hoyes Michalos today for a free consultation to understand which debt solution best matches your needs.
