It’s important to distinguish between the effects of the debt consolidation loan and the actions of the borrower after that loan is processed. Those who claim that debt consolidation “ruined” their credit did not do it properly. There’s more to this than simply borrowing money to pay off outstanding credit card balances. Behavioral changes are necessary also.
What is Debt Consolidation?
When you consolidate debt, you take out a new loan to pay down high-interest debt. In doing so, you are rolling all your payments into one monthly bill, ideally with a fixed interest rate. There are several ways to consolidate. The most common methods are personal loans and balance transfer credit cards.
Should I Consolidate my Debt?
Depending on your financial situation and the approach you use, consolidating debt could save you money and help your credit score. Consolidation could also cost you in fees, interest, and more debt that hurts your score. Find out if debt consolidation is a good idea for you.
Debt Consolidation and Credit Scores
Proper management of consolidated debt can boost your credit score. It can improve your payment history, reduce what you owe, and more. If mishandled, consolidation could damage your score. Knowing what goes into your credit score makes this relationship easier to understand.
FICO weighs the following:
- Payment history (35%): Timeliness of payments, history of accounts in collection or bankruptcy
- Amount owed (30%): Your credit utilization rate (amount owed divided by credit limit); lower is better
- Age of credit (15%): How long accounts have been open; older is better
- Credit mix (10%): Account types; diversity is preferred
- New credit applications (10%): Hard credit inquiries, applications for multiple accounts in a short period; fewer is better
How to Consolidate Debt Without Hurting Your Credit
Some lenders will pay your credit cards off for you when they approve you for a debt consolidation loan. If not, your best choice is to pay them yourself immediately. Get the money out of your hands before you spend it on something it wasn’t intended for. In some cases, there will be a few dollars left over when you’re done. Spend that if you like.
The next step, if you want to avoid hurting your credit score, is to put your credit cards away. Don’t cut them up because you may need the security codes on the back to contest fraudulent purchases or identity theft. Hide the cards in a drawer and make a commitment not to use them until the loan is paid off. As the loan balance comes down, your credit score will go up.
How Debt Consolidation Can Help Your Credit Score
Paying just the minimum monthly payments on credit cards will not lower your balances quickly. A certain percentage of that payment goes to interest, with only a small portion coming off the principal. One of the factors used to calculate your credit score is “amounts owed.” Making minimum payments isn’t going to move that needle very much.
A debt consolidation loan will pay off those outstanding credit card balances all at once and put you on a system where you’re making a fixed monthly payment on the loan. You’ll have a set amount of time to pay the loan off, and each payment is reported to the credit bureaus. Make your payments on time and your score will go up as the balance comes down.
What Happens to Your Credit After Debt Consolidation?
What happens to your credit after debt consolidation will be determined by your spending behaviors both during the loan period and immediately following it. If you don’t use your credit cards and pay off the loan balance in full, your credit score should be in the “good” or “exceptional” range by the time you’re finished. If you’re still spending, it won’t be.
Ways to Consolidate Your Debt
There are several ways to consolidate debt, but the two most common are balance transfer credit cards and personal loans. If you’re a homeowner, you could also consider a home equity loan or home equity line of credit (HELOC). Both are secured loans, so interest rates should be lower. If you’re not a homeowner, choose one of the following:
1. Consolidate with a Balance Transfer Credit Card
Credit card companies looking for new customers sometimes offer an introductory period when you can transfer balances and get a 0% interest rate. That rate can last a few months, a year, or longer. If you feel you can comfortably pay off your outstanding balances in that time, this could be a good option for you. Search for “balance transfer credit cards” online.
- A good or excellent credit score can land a lower interest rate plus 0% APR introductory period.
- Consistent payments can boost your credit score.
- Qualifying for a higher credit limit lowers your credit utilization ratio, improving your credit score.
- A hard inquiry will temporarily impact your score
- Not repaying before the intro period ends means higher interest rates and payments. This can lead to missed payments, affecting your score.
- May increase your credit utilization, hurting your score.
2. Consolidate with a Personal Loan
This is a more common way to consolidate debt and a good option if you have multiple credit cards and outstanding loans. A personal loan to cover the total amount owed could lower your interest rates and condense all your debt payments into one single monthly loan payment. Interest rates on personal loans average roughly 9-10%.
- Qualify with a lower credit score than necessary for a balance transfer card.
- Consistent payments can boost your credit score.
- Can improve your credit mix and boost your credit score.
- May lower your credit utilization ratio, improving your credit score.
- May include a hard inquiry that will briefly lower your score.
- May lead to more debt if you use space on your old cards, raising your credit utilization ratio and lowering your credit score.
- Failure to make payments will harm your score.
Additional Ways to Consolidate
Other debt consolidation methods may also impact your credit score.
- Debt Management Plans (DMP): Working with a credit counselor or debt settlement company won’t affect your score unless you sign up for a DMP. A debt management plan involves negotiating for a lower repayment and stays on your credit report until completed.
- Home equity loan or HELOC: Either method will impact your score as they figure into your credit mix, amount owed, and payment history. Includes a credit check, which will temporarily lower your score.
- 401k loan: This type of loan is not included in your credit report and will not affect your credit score.
The Bottom Line: Debt Consolidation Doesn’t Hurt Your Credit Score
Debt consolidation doesn’t hurt your credit score, but your actions could if you’re not careful with your spending habits while you’re paying off that loan. Many consumers fall into this trap. They borrow money, pay off their credit cards, then charge them back up again. If you can avoid doing that, debt consolidation will be the right option for you.
Frequently Asked Questions
How does debt consolidation impact your credit score in the short-term?
In the short-term, taking out a debt consolidation loan will drop your credit score by a few points because the lender does a “hard inquiry” on your credit report and you’re taking on new debt. The score will go back up in a few months if you pay off your credit cards.
How do you get the most out of debt consolidation without hurting your credit?
You can get the most out of debt consolidation if you change your spending habits and don’t use your credit cards. Making your loan payments on time and not taking on any new debt will increase your credit score over time.