Lose debt first, protect credit later

I enrolled in a debt-management plan in August 2003 and have finally finished paying off all my credit cards. I would like to find out if having used the agency will hurt my credit score.

As a single mom, I have worked hard to clear my debts and put myself in a better financial situation, but I need to bolster my assets (buying a home, increasing retirement savings, building a college fund for my little one) to increase my net worth.

I don't have any other outstanding debts or loans, but will that work against me now? Given my situation, is there a best way to begin? -- Colleen

Dear Colleen,

Congratulations on successfully paying off your credit-card debt! From your letter, it sounds like you have set some great financial goals for yourself. That is a good motivator to keep you out of problem debt again.

Some of my readers may be wondering why you didn't consider the potential damage to your credit before going on the debt-management plan, known as a DMP. My answer is that it really didn't matter because the essential goal was to pay off the debts that were plaguing you and your family.

Your credit rightly took second or even third place in importance. Had you avoided the debt-management plan simply to protect your credit, it would have been like telling the doctor you can't lose weight because you are afraid your clothes won't fit anymore. Or, that you can't stop smoking because you might gain weight.

Trust me, you were right: Lose the debt first, take care of the credit second.

I am often asked about how a DMP will affect a credit score. The answer is threefold. First, the fact that your accounts were part of a debt-management plan is not included when calculating your credit score.

Second, any negative information that occurred on those accounts before or while you were on the program is included in factoring your score. So if you were 60 to 90 days late on your accounts when you began the debt-management plan, it will negatively affect your score. Also, missing any payments while on the program will also lower your score.

Third, how an account is reported depends on the policies and systems capability for each individual creditor. For example, a given creditor may accept a reduced payment with lower interest and no fees under a DMP, but may report the original payment amount as due to the credit bureau. This will cause a negative to appear on your credit report.

This inconsistency can be caused by inflexible internal management policies or systems that cannot easily be reprogrammed to accept lower rates and payments.

The only way to know for sure to see where you stand is to get a copy of your three credit reports. I recommend you go to AnnualCreditReport.com and request your free annual credit report from all three major credit bureaus. I would also pay to receive your credit score. It's cheaper to get your score with the free report and it will help you understand how all the information on the report adds up.

Each bureau also has some good credit tips on its own Web site, as do the FICO people at myFICO. Review your credit reports carefully and make sure everything is correct. If not, dispute any inaccurate information with the bureau that reported it.

You are correct in believing that having no outstanding debts or loans will not help with your goal of purchasing a home. Without any open accounts, it will be difficult to improve your score.

My suggestion is to begin opening credit accounts during this year, before you purchase a home. Your goal should be to have different types of accounts -- an installment loan (such as a furniture loan), a passbook loan and some revolving accounts, such as a credit card.

Pay on time and as agreed and you will build a positive credit history that will move you toward your goal of homeownership.

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