Is Debt Consolidation Hurting Your Credit? – Councilor Forbes
Editorial Note: We earn a commission on partner links on Forbes Advisor. Commissions do not affect the opinions or ratings of our editors.
Find out if you qualify for debt relief
Free estimate without obligation
If you’re having trouble paying your bills or want to get out of debt faster, debt consolidation might be a solution. But before going ahead with this method of debt relief, it is important to understand what it does to your credit, how the process works, and your other options.
Here’s a more in-depth look at how debt consolidation works.
How Does Debt Consolidation Work?
Debt consolidation is a form of debt relief that typically involves taking out a new loan to pay off previous loans, combining the debts – consolidating them – into one monthly payment. Debt consolidation can offer several benefits, such as lowering your interest rate, simplifying your monthly payments, and deleveraging faster.
If you’re trying to decide if debt consolidation is a good idea, start by looking at your overall financial life. Debt consolidation might be a solution if you’re struggling to pay your bills, aren’t comfortable with your current debt amount, or you’re unhappy with interest rates (APR ) your existing credit cards or loans.
However, it is also important to know how debt consolidation can change your credit rating. Take care to manage your credit score while paying off your debts.
How Debt Consolidation Affects Your Credit
Debt consolidation could have an impact on your credit score, both good and bad. Below are five ways that debt consolidation could positively or negatively affect your credit score.
1. It could cause difficult questions on your credit
Whenever you officially apply for credit, the creditor does a thorough investigation, also known as a credit withdrawal, to check your creditworthiness. Each serious request usually reduces your credit score by a few points. If you shop around and apply for debt consolidation loans from multiple banks at once, your credit could be temporarily affected. Fortunately, many inquiries over a period of time, ranging from 14 to 45 days, are usually combined into one when your credit score is calculated.
Remember that a thorough investigation is not necessary every time you speak to a lender or visit a website. It is possible to do your research and be prequalified for a loan without having to go through the rigorous investigation process. Many lenders will allow you to shop for rates and prequalify online with a smooth credit check, or smooth draw, that doesn’t affect your credit score. This allows you to take the first steps to see if you qualify for a loan, but without undermining your credit.
Before you decide to go ahead with a lender, read the fine print and make sure you understand whether or not you are ready to have your credit checked with a thorough investigation as part of the loan application process.
2. Your credit usage may change.
Creditors and rating agencies pay attention to your credit utilization rate, which is roughly 30% of your FICO credit score. Your credit utilization rate is the percentage of available credit that you are using at all times. For example, if you have a credit card with a credit limit of $ 15,000 and a balance of $ 4,500, your credit utilization rate would be 30%.
If your credit utilization rate increases after debt consolidation, it could negatively impact your credit score. Using the example above, if you transfer your existing credit card balance of $ 4,500 with a limit of $ 15,000 to a new credit card with a credit limit of $ 7,500, your rate will drop. The credit usage on this new card will be 60%, which could result in a knock on your credit score.
On the other hand, if you consolidate multiple credit card debts into one new personal loan, your credit utilization rate and credit rating might improve. Credit cards and personal loans are considered two separate types of debt when assessing your credit mix, which represents 10% of your FICO credit score.
For example, let’s say you have three credit cards. Again, using the example above:
- The first card has a balance of $ 4,500 with a credit limit of $ 15,000.
- The second card has a balance of $ 2,000 with a credit limit of $ 10,000.
- The third card has a balance of $ 5,000 with a credit limit of $ 10,000.
You would have credit usage rates of 30%, 20%, and 50%, respectively, for these three cards. (By combining the cards, your overall credit usage is almost 33%.) If you combine these three debts into a new personal loan of $ 11,500, the credit usage ratios for each of these three cards will drop to zero (as long as you keep the credit card accounts open and you don’t spend extra on the cards), which could improve your credit score.
3. The average age of your accounts may drop
Another factor in determining your credit score is the average age of your accounts, or how long you’ve had those accounts. This shows the overall length of your credit history and represents approximately 15% of your FICO credit score.
If you’re opening a new credit account as part of your debt consolidation plan, whether it’s a new credit card with balance transfer or a new personal loan, the average age of accounts decrease and you may experience a drop in your credit rating. But depending on how many other credit accounts you have and your overall credit history, the drop may not be significant.
4. It can improve your long term payment history.
Payment history represents approximately 35% of your credit score. If you already have a solid track record of making on-time payments, debt consolidation may not affect this aspect of your credit score. But if consolidating your debt into a new loan at a lower interest rate makes it easier for you to make payments on time, then debt consolidation could help improve your long-term credit score.
5. It may cause you to close accounts
If you are going through the debt consolidation process, it can be nice to close your old accounts after a balance transfer or getting a new loan. But be careful. Closing a credit account could reduce the average age of your accounts or increase your credit utilization rate. Both of these actions can hurt your credit score.
After you have completed your debt consolidation process, consider leaving your old credit accounts open but with zero balances. Keeping these accounts open and on your credit report can be good for your credit score, as long as you’re not tempted to use them to rack up more debt.
Ways to consolidate your debt
There are several ways to consolidate debt:
- Debt Consolidation Loans. Debt consolidation loans are a type of personal loan available from banks, credit unions, and online lenders. With this type of loan, lenders can pay off your debt directly or provide the borrower with cash to pay off their outstanding balances.
- Personal loans. With a personal loan used for debt consolidation, you take out a new loan from a bank, credit union, or other lender to pay off higher interest debt, such as credit card debt. credit or other bills.
- Balance transfer credit card. If you have sufficient credit, you can transfer balances from multiple credit cards to a new credit card with balance transfer at a lower interest rate, sometimes 0% APR for an introductory period.
- Home equity loan. If you own your home and have accumulated enough equity to qualify, you may be able to use a Home Equity Loan or Home Equity Line of Credit (HELOC) to consolidate your debt at a low rate. ‘lower interest.
- Mortgage refinancing with withdrawal. Withdrawal mortgage refinancing gives you the option of refinancing your home for more than the outstanding balance. You can use the difference in cash to pay off unpaid debts.
Alternatives to debt consolidation
If you don’t want to take out a new loan, open a credit card, or use the equity in your home to consolidate your debt, there are several other alternatives:
- Pay your debts yourself. If your debt payments are manageable, you can make a plan to pay off your debt faster. If you have enough income and space in your monthly budget, you may be able to pay off your debts quickly without debt consolidation, using the snowball or debt flood method.
- Enter a Debt Management Program (DMP). If you’re having trouble paying your bills, you can work with a nonprofit consumer credit counseling agency to set up a debt management program where you agree to pay off your debts with a monthly payment. to the credit counseling agency, which then pays your creditors for you.
- File for bankruptcy. If you’re struggling to pay your bills, don’t want (or can’t get approved) to borrow money anymore, and you don’t think you can pay off your debts, you may consider filing for bankruptcy. This legal process can erase some or all of your debt and help you get a fresh start. But be aware that bankruptcy stays on your credit report for seven to 10 years.
- Consider debt settlement, but as a last resort. If you’ve fallen behind on your debts, you may want to consider negotiating with your creditors to accept less money than you owe. This is called debt settlement, and you can do it yourself or by working with a debt settlement company. But be careful. Debt settlement can be risky. Creditors are not required to accept your debt settlement offer and may be unwilling to negotiate. And the debt settlement process usually causes significant damage to your credit. It should only be considered as a last resort.
Is Debt Consolidation Hurting Your Credit? It depends. If you are using debt consolidation as a strategy to get out of debt, you may need to prepare for a short-term drop in your credit rating. But when you can manage your payments responsibly and start making progress on paying off your debt, debt consolidation can help you prepare for better credit and a stronger financial future.
Find out if you qualify for debt relief
Free estimate without obligation