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Debt consolidation is a common strategy used by consumers to combine multiple debts into one new loan with the goal of simplifying payments and saving money on interest. However since debt consolidation involves taking on new debt, many consumers worry it could actually hurt their credit scores.
The truth is, debt consolidation can both help and potentially hurt your credit, depending on how it’s done The key is understanding the different ways debt consolidation can impact your credit profile, both positively and negatively Armed with this knowledge, you can make an informed decision about whether consolidation is the right debt payoff method for your situation.
How Debt Consolidation Can Improve Your Credit
When done responsibly, debt consolidation offers several benefits that may boost your credit scores over time
1. Lower Credit Utilization
Your credit utilization ratio, which is the percentage of your total available credit that you’re using, makes up 30% of your FICO credit score. The lower your utilization, the better for your credit score.
If you consolidate multiple credit cards down to one loan, your total balances owed will remain the same, but your overall utilization will likely decrease since you’ve eliminated those card balances. This can give your score an immediate boost.
2. Fewer Accounts with Balances
While having a mix of credit types is good, carrying balances on multiple accounts can negatively impact your score. When you consolidate debt, you eliminate balances on the old accounts and are left with just one loan balance. Having fewer accounts with unpaid balances also looks better for your credit.
3. Opportunity to Improve Payment History
If high-interest debts were a struggle to pay before, consolidation can make it easier to avoid missed payments and keep your new loan repayment history spotless. Positive payment history is the most important factor in your credit scores.
4. Lower Interest Rates
A major benefit of debt consolidation loans is the lower interest rate compared to high-rate credit card debt. This means more of your payment goes to paying down principal rather than interest, helping you get out of debt faster.
5. Pay Off Debt Completely
Once you’ve consolidated your debts, commit to paying off your new loan on time and in full. Completely eliminating debt improves your credit utilization and mix of credit, and builds positive payment history – all of which helps to raise your credit score.
How Debt Consolidation Can Hurt Your Credit
While the potential benefits clearly exist, it’s also important to be aware of how debt consolidation could negatively impact your credit:
1. Credit Inquiries from Applications
Applying for a consolidation loan triggers hard inquiries on your credit reports, which can lower your scores a few points. Too many inquiries in a short period is seen negatively by lenders. Avoid applying unless you’re likely to be approved.
2. Opening a New Account
As a new debt obligation, the consolidation loan will show up on your credit reports and can lower the average age of your accounts. Older accounts help your credit, so new accounts tend to lower scores temporarily.
3. Potentially Higher Debt Load
It’s crucial to avoid the temptation to rack up more balances on the credit cards you paid off. Your total debt could end up higher than before consolidation, hurting your credit utilization and scores.
4. Risk of Missed Payments
If your monthly payments don’t end up being more affordable through consolidation, missed payments on your new loan could quickly damage your credit profile and scores. Be realistic about the payment.
5. Account Closures
Closing old credit card accounts can ding your credit scores if you have limited accounts open. Try to keep them open even after consolidating the balances.
Tips for Protecting Your Credit Through Debt Consolidation
If you approach debt consolidation carefully, you can avoid potential credit pitfalls and even improve your scores. Here are some tips:
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Compare interest rates across lenders to ensure you get the lowest rate possible on your consolidation loan. This will maximize interest savings.
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Avoid applying for new credit cards or other loans while paying off your consolidated debt. Hard inquiries and new accounts should be minimized.
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Make sure your consolidated monthly payment is affordable based on your budget. Missing payments will undo any credit benefit.
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Keep old accounts open rather than closing them. Even unused credit cards help your credit utilization and history.
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Pay more than the minimum when possible to pay off the consolidation loan faster. The quicker it’s paid, the more your credit stands to improve.
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Monitor your credit reports regularly to ensure on-time payments are being reported properly. Dispute any errors immediately.
The Bottom Line
Overall, used strategically, debt consolidation can help many consumers improve their credit profile over time through lower balances, fewer accounts with debt, lower interest costs, and the opportunity to more easily build positive payment history. Just be careful to avoid potential pitfalls like overspending or taking on debt that remains unaffordable to pay off.
Ways debt consolidation can help your credit score
- Builds a history of on-time payments: Responsible repayment behavior is the most important factor in calculating your credit score. If you take out a loan to pay off your debt, and then make all the loan payments on time, it could help build your score.Â
- Lowers your credit utilization: Your credit utilization, or the amount of available credit youâre currently using, accounts for 30% of your credit score. Generally, the lower your credit utilization, the better your score. If you consolidate your debts, then successfully pay them off, your credit utilization ratio should go down.Â
- Can help diversify your credit mix: Juggling a few different types of credit products may help grow your score. For example, if you have revolving credit, like credit cards, adding installment credit, like a debt consolidation loan, could show credit diversity.
Does debt consolidation affect your credit?
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