Does debt consolidation hurt your credit? You want to get rid of that mountain of debt, but debt consolidation could damage your credit.
This is a legitimate concern. It’s essential to address the problem and not make it worse.
Good news: Debt consolidation can improve your credit score.
Consolidating your debts means you can combine all of your credit card bills into one lower-interest pile with one monthly payment.
There are many options for debt consolidation. Some have a more significant impact on credit than others. You can choose from debt management plans, credit card balance transfers, and personal loans. However, you might also consider a loan, line credit, or a 401(k).
- 1 How much does consolidating debt affect your credit score?
- 2 Consolidated Debt Can Impact Credit Factors
- 3 Consolidating debt with a personal loan
- 4 Consolidating Debt and a Balance Transfer
- 5 There are other ways to consolidate debt.
- 6 How debt consolidation can help your credit
How much does consolidating debt affect your credit score?
For a variety of reasons, most debt consolidation programs will temporarily lower credit scores. Debt management plans, for example, require you to stop using credit cards. You can reduce your credit score by canceling a credit card.
Lenders will make a “hard inquiry” about your credit when you apply for consolidation loans. This lowers your score by a few percentage points. The credit bureaus will treat multiple inquiries made within a short time (usually 14 to 45 days) as one inquiry if you are shopping for the best option.
However, questions spread over a more extended period will be viewed as desperate attempts to get credit and a more significant impact.
The method used to consolidate debt will also impact the outcome. While loans and balance transfers can have many negative consequences, debt management plans are very few.
Whatever method you use, the most crucial factor in how debt consolidation affects your credit is how well you treat the recognition that you already have.
Late payments impact your credit score on loans, credit cards, and other bills. For seven years, a cost that is 30 days late will remain on your credit score.
To maintain credit and repair bad credit, it is crucial to make timely payments.
It is important not to accumulate more debt after you have made a debt consolidation move. Do not think that a consolidation loan will pay off your credit card bills and allow you to use the cards again recklessly. This is a recipe for more trouble.
Consolidated Debt Can Impact Credit Factors
While many debt consolidation options may have some minor credit-related adverse effects, these are temporary. These consolidation options will have long-lasting positive effects.
The three largest credit reporting agencies – Experian and Equifax – consider many factors when determining credit scores.
Credit Negative Effects
- Hard inquiries are made when credit applications are submitted. This can temporarily lower your credit score by a few points. However, multiple applications over a more extended time will have a more significant impact.
- A new account does not have a payment history until consistent on-time payments are made.
- Credit accounts tend to be less old with each new tab. The older the average credit age, the better.
- If the debt is transferred to a credit card with a lower limit, the credit utilization rate will rise. This will result in a lower credit score.
Positive Effects on Credit
- Credit utilization rates will drop if a debt is transferred onto a card with higher limits or if a credit account balance is paid off using a loan.
- Credit score will improve if you make timely payments.
Consolidating debt with a personal loan
If you have 680 credit or higher, a personal loan can be a great way to consolidate your debt. If you have a low credit score, obtaining a financially sound loan will be more challenging. High-interest rates and fees may erase any savings.
Keep credit’s adverse effects low by only borrowing what you need to repay your debt. You could end up with a higher debt load if you borrow more than you need.
Reminder: Don’t let the loan harm your credit score.
The Consumer Financial Protection Bureau warns that if you take out a consolidation loan and continue to make more credit purchases, you won’t be able to pay down your debt.
As with all things, there are pros to consolidating your debt with a Personal Loan.
The pros and cons of debt consolidation loans
- The interest rate should be lower than the amount of credit card debt.
- Combining multiple bill payments into one monthly installment
- The monthly payment is the same and lasts for a set amount of time. Usually, it’s 3 to 5 years.
- These cards don’t require a high credit score like balance transfer cards.
- They can reduce credit utilization.
- They are not secured, unlike home equity loans or collateral-based loans.
- You may also receive special offers like direct payment to creditors or free credit score monitoring.
Cons of debt consolidation loans
- To get the best interest rates, you must have good credit.
- There may be loan fees.
- The loan can be more expensive than anticipated due to prepayments and exit fees.
- If used to repay credit cards, it could lead to increased debt, and the cards are still being used.
Consolidating Debt and a Balance Transfer
Balance transfers are a way to transfer credit card debt onto a lower-interest or zero-interest card. This works for those with a good credit score of 700 or higher.
You may not be eligible if your score is below 700. If you are, you will probably end up paying fees and have to pay a temporary limit on the introductory rate. After that, you’ll likely go back to where you were. Or worse.
The benefits of a balance transfer lower initial interest rate are generally 0% AP for those with excellent to good credit ratings.
- Credit card debt can be combined onto a lower interest card with one monthly installment.
- The credit utilization rate can be lowered to improve credit.
Cons of Balance Transfer
- You can’t transfer money to the same bank using the same card.
- Transfer fees are usually between 3% and 5% for most cards. For example, $5,000 worth of funds can be transferred to a card that charges $150 to $250.
- Transfers must be made within 60 days of opening the account. Otherwise, you will not get the 0% APR.
- The low-interest-rate lasts for a short time, usually six to 18 months. After that, the rate rises to around 24% on any balance.
- The 0% rate might not be applicable if you use the card to make purchases.
- The amount that can be transferred by card issuers is usually limited to a specific dollar amount or a percentage of the total credit limit. They also include fees in the calculation.
- Credit scores can be affected if debts that were transferred continue to be used. This could lead to higher debt and credit utilization.
There are other ways to consolidate debt.
Consolidating debt can be done in other ways. Some of these have no or little impact on your credit score but could have a long-term effect once the debt is paid off.
Plans for Debt Management
A debt management program consolidates your debt and has a low impact on your credit score. It also has long-term potential positive effects.
This doesn’t require you to take out a loan, increase your credit or make any changes in your credit score. One fixed monthly payment is made to a nonprofit debt management firm, usually three to five years.
The company will distribute the money to your creditors. Once the plan is completed, it will be noted on your credit reports. While closing credit card accounts can lower your credit score, timely payments will improve your credit rating. Monthly administrative fees are charged for debt management plans.
Home Equity Loans or Lines of Credit
Homeowners have the option to use equity from their home to get a lump-sum loan or a line of credit (HELOC) to consolidate debt.
This loan has the same effect on credit scores as any other loan. Your credit score will be higher if you pay on time, and your score will drop if you miss payments.
You use your home as collateral and could lose it if you fail to make your payments on time. It is similar to a home equity loan, but it is a lump sum and not a revolving credit line.
You are borrowing from your 401(k).
A or 401(k) loan is a loan that you take out from your retirement savings. It does not affect your credit. However, it will cost you money.
You will pay a 10% penalty if you withdraw the money before turning 59-1/2. Then, the tax will be added to the amount that you start. Also, an interest previously exempted from income tax you had invested in retirement is not being accrued. This is not a viable option. Instead, explore other options.
If there are no other options, bankruptcy filings should be considered. This can harm your credit score. Your credit report will remain unchanged for ten years after a Chapter 7 bankruptcy.
A Chapter 13 bankruptcy remains on your credit report for seven-year. These can harm your ability to buy a house, rent an apartment, or purchase a car.
How debt consolidation can help your credit
Consolidating debt can have a positive impact on your credit score if done correctly. Consolidating your debt can reduce your debt and establish a foundation for regular on-time payments. This can help boost your credit score.
But where should you begin?
According to the Consumer Financial Protection Bureau, it is good to contact a credit counselor if you have credit problems before you start consolidating debt.
An accredited credit counselor can help you understand debt relief options and determine the best method to consolidate debt for your financial situation.
Non-profit credit counseling agencies that are accredited offer free counseling. Counselors can help you evaluate your budget, assess debt consolidation options, and recommend solutions. For-profit agencies may charge a fee for counseling.
Do your research before you meet with a counselor.