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Does debt consolidation hurt your credit?

Debt consolidation loans can cause a dip in your credit score, but it's temporary. Learn how you can consolidate debt with minimal changes to your credit score.

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Consolidating your debts can temporarily lower your credit score, and then improve it in the long-term. So, while there are some risks to keep in mind, debt consolidation is generally a worthy consideration if you’re looking to build credit.

Besides, consolidating debts into one payment makes everything easier to handle since you’re only left with one debt to worry about. But more importantly, it can lower your interest rate and thus monthly payment. This makes debt consolidation one of the most practical solutions if you’ve been accruing high balances on loans, mortgages and credit cards.

However, consolidating debts is not completely free of drawbacks. For example, it can temporarily dip your credit score. In this guide, we explain exactly how debt consolidation affects your credit and how you can minimize the impact.

The key takeaways

  • Debt consolidation will temporarily hurt your credit score because it triggers a hard inquiry and may also affect your credit mix and credit utilization ratio.
  • You can minimize the effects of debt consolidation on your credit score by making timely payments and maintaining a low credit utilization ratio.
  • The most common types of debt consolidation are balance transfer cards and debt consolidation loans.
  • The best time to consolidate your debts is when market rates are lower than the rates currently charged on your loans and credit cards.
  • If you’re not completely sold on debt consolidation, you can look into a debt management plan, a 401(k) loan or a budget overhaul as an alternative to managing your debts.

How does debt consolidation work?

In short, debt consolidation provides debt relief by refinancing multiple loans that you have into a single loan with a new lender. Borrowers typically consolidate loans to take advantage of low interest rates, which translate to lower monthly debt payments.

An added benefit of consolidating debt is that it rolls all your loans into one. This makes it easier to manage the debt compared to if you have multiple loans to keep track of. There are several ways of consolidating your debts, but the two most common methods are balance transfer cards and debt consolidation loans.

A credit card balance transfer involves moving your high-interest credit card debt to a different credit card company that offers lower interest rates. By doing so, you get to take advantage of the low rates, which can drastically reduce your monthly payment. Additionally, most credit card issuers offer an interest-free introductory period of between six and 18 months. This can give you ample time to plan your finances and meet the obligations that come with the new credit card.

The second popular method of debt consolidation is using a refinance loan. This can either be a personal loan, home equity loan, or home equity line of credit (HELOC). Whatever the case, you will use the proceeds of your new loan to pay off all the old loans. This leaves you with only the new loan (which is typically cheaper) to worry about.

The bottom line is, refinancing makes sense on a financial level – whether you choose credit card balance transfer or a refinance loan. But do debt consolidation loans hurt your credit?

Does debt consolidation hurt your credit?

Consolidating your debts can temporarily dip your credit score by a few points for a few months. However, the overall effect should be a rise in the score as long as you make timely payments, maintain a low credit utilization ratio (available credit vs overall credit limit), and follow all the best practices for building credit history. For example, if you only have credit card debt, you can take out an affordable loan in order to improve your credit mix and push your fico score upwards.

Timely payments are especially important after debt consolidation. Your payment history usually contributes about 35% of your credit score. Thus, any late and/or missed payments can seriously hurt your credit score long after debt consolidation. And of course, it’s important that you avoid the mistakes that led to the need for a refinance in the first place. One benefit of debt consolidation is it’s more likely that you’ll have fewer late payments if you only have one bill to pay each month.

How debt consolidation can affect your credit

The point of consolidating debts is to roll all of them into one manageable loan, ideally with a lower interest rate and monthly payment. Having one, affordable loan can help you pay it off faster because more of your monthly payments will go towards repaying the principal rather than paying interest if your interest rate is lower or your term is shorter. However, debt consolidation is not entirely free of risk on your credit. Here’s how it can negatively impact your credit score:

Lender may perform a hard inquiry

When you consolidate your debts, you essentially take on a new loan, which triggers a hard credit check on your credit report. Every hard inquiry may lower your credit by up to 10 points. The good news is that the impact lasts for a maximum of one year, and many people with good credit or excellent credit have hard credit inquiries on their credit report.

Credit utilization ratio can increase

This is particularly a risk if you do a credit card balance transfer. Your new credit card may come with a lower limit, thus increasing your credit utilization ratio. This ratio accounts for up to 30% of your credit score. The higher it is, the more hurtful it is to your overall credit score.

Ideally, you want to keep the credit utilization ratio under 10%, but you’ll usually be fine as long as it is below 30%. Something to keep in mind is that if you take out a loan to pay down your credit card , your credit utilization ratio will almost certainly drop and your credit score will improve.

Debt consolidation may require closing accounts

Holding a credit account for a long period improves your credit score. For example, a 10-year-old account will earn you more points than a newly opened account. Credit bureaus typically take the average age of all your accounts into consideration when calculating your credit score. The resultant age contributes roughly 15% of your final credit score.

Unfortunately, when you consolidate your debts, you may be forced to close some credit accounts and remain with one new account. This decreases the average age of your credit accounts and thus your credit score.

Luckily, there’s a way around this problem – particularly if you’re consolidating credit card debts. Rather than closing the old credit card accounts, keep them all open for a period of time even if you’re not planning to use them. They’ll still contribute to your average age of credit accounts and decrease your credit utilization ratio.

Pros and cons of debt consolidation

Consolidating your debts comes with some advantages and disadvantages. The biggest benefit is that you may get your hands on a low-interest loan, which can help lower your monthly payment. On the downside, debt consolidation will hurt your credit score temporarily. Here’s a detailed look at the advantages and disadvantages of debt consolidation:

Pros

  • Debt consolidation can improve your credit mix, especially if you only had credit card loans and are now taking up a new personal, home equity (for homeowners) or HELOC loan.
  • You may get approved with a lower credit score, particularly if you opt for a loan rather than a credit card balance transfer.
  • Debt refinancing typically lowers interest rate and thus your monthly payment.
  • Combining multiple debts into one simplifies your finances. You won’t have to keep track of several loans at once.
  • Credit card balance transfers typically come with attractive terms like no-interest periods of six to 18 months.

Cons

  • Debt consolidation will lower your credit score. It’s a temporary dip, but it’s a point reduction nonetheless.
  • Some refinance loans come with prepayment penalties, which often lock borrowers in a fixed payment plan.
  • Without timely payments, a debt consolidation effort will hurt your credit score more.
  • It’s riskier to replace an unsecured debt like credit card with a secured debt like a home equity loan or HELOC. If you fail to make payments, you may lose the house.
  • Sometimes it might make more sense to go with debt settlement rather than consolidation.

How to consolidate your debt

The typical way to consolidate your debt is to start with listing all your current credit cards and loans. Itemize them, along with their total balances, monthly payments, interest rates, and number of remaining payments.

Next, compare the rates on your loans and current market rates. Usually, you’ll only reap the financial benefits of debt consolidation if you can get lower rates than what you’re currently paying. Otherwise, refinancing to a higher interest rate will likely increase your monthly payment. While at it, make sure to also compare the interest rates offered by various lenders to see who has the best deals.

Go ahead and choose the type of debt consolidation that makes sense to you. It may be a balance transfer credit card, a personal refinance loan, a home equity loan or a home equity line of credit. Whatever the case, get quotes from various lenders and compare their APRs, total interest, terms of lending etc. Obviously, you want a lender whose terms are friendly to your current financial situation.

Determine how much loan you qualify for. Again, debt consolidation will work best if the amount you’re getting can fully pay off the loans you’re consolidating. Otherwise, you may be left with all or some of the current loans, as well as a new loan that couldn’t fully consolidate the current ones. You may need a free loan calculator to figure how much you qualify for and if it will be enough to consolidate your current debts.

Keep in mind that you may need to apply for more than one loan or perhaps a loan and a credit card to fully pay off all the current debts. If that’s the case, you might want to apply for them within a span of two weeks since multiple hard inquiries for the same loan type only counts as one hard inquiry on your credit report.

Once you have all the above figured out, request offers from your top pick lenders. Choose one and apply for the loan and/or credit card. When you receive the funds, pay off your current debts and start repaying the new loan.

When does it make sense to consolidate your debts?

The most common and best reason to consolidate debts is to get lower interest rates and reduce your monthly payment. It, therefore, makes sense to do debt consolidation when market rates (along with their associated fees) are lower than the rate you are currently locked in. You could potentially save hundreds or even thousands by lowering your interest rate and monthly payment.

Besides that, it also makes sense to consolidate your debts if you have too many credit accounts. Juggling multiple loans and credit cards can be quite tricky, and you may find it hard to keep up with all the due dates. To simplify everything, you can consolidate the debts so that you only remain with one new debt to focus on. You may also have other types of debt such as student loans, installment loans, auto loans, or home loans.

Alternatives to debt consolidation loans

So, what does debt consolidation do to your credit score? It hurts your credit score, at least temporarily. If that’s not something you want to experience, you’ll be glad to know that there are alternatives to debt consolidation.

  • Debt management plan: feeling overwhelmed by your debts? Consider signing up for a debt management plan. Typically offered by credit counselor agencies, this service may see you pay less than the full amount on your loans and credit cards. However, keep in mind that getting into a debt management plan will hurt your credit score for as long as the plan is active. Once completed, it won’t have an effect on your credit.
  • Budget overhaul: if you feel that the reason behind your multiple debts has to do with your spending, then it may be possible to evaluate your budget and try paying off the debts rather than consolidating them. You can, for instance, cut down on your purchases, skip purchasing a new car, and take up a side hustle to pay off debts. It may seem like a hassle, but it can work, especially if your debts are related to your credit card spending.

Final thoughts

While it may temporarily hurt your credit score, debt consolidation is usually a good idea in the long-term. That’s because it gives you a chance to get a lower interest rate and reduce your monthly payment. Plus, it bundles up all your current loans and credit card debts into one new loan that’s easier to manage. However, for it to work, you will have to shop for lenders with the friendliest terms and low interest rates. You’ll also need to create a repayment plan and stick to it so that your credit score can bounce back faster.

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