How Does Debt Consolidation Affect Your Credit?
If you’re one of the millions of Americans who carry consumer debt, perhaps you’ve thought about debt consolidation.
But how does debt consolidation affect your credit? The short answer is that it can have a positive or negative effect. So before you consolidate, it’s important to understand how it can help — or hurt — your overall credit.
Let’s break down some of the real-life impacts of debt consolidation — and explore some actionable tips for monitoring and improving your credit score during the process.
How can debt consolidation help your credit?
When you consolidate debt, you combine multiple debts into one new loan or credit card balance, usually with a lower interest rate. While this means you have a smaller amount of monthly bills coming in, does debt consolidation actually help your credit?
Here are some of the primary benefits of consolidating your debt.
Paying down debt.
When you move higher-interest balances to lower-interest accounts, it means more of your monthly payment can go towards the balance itself. This helps you pay down your existing debt faster. And maintaining a healthy mix of accounts that you are able to manage and pay consistently over time can demonstrate responsibility to creditors and credit bureaus.
Lower credit utilization ratio.
The ratio of your revolving debt to your total available credit is also a factor in your credit score. In other words, if a high percentage of your credit limit is currently used, you might appear to be over-leveraged — a risk factor to creditors. But if you have a large amount of available credit left unused, it’s a positive factor. Experts typically recommend keeping your utilization ratio below 30%.
Additionally, when you do pay off a credit card in its entirety you may not want to close it. This way, the available credit limit on that account is still working in your favor to help keep your credit utilization ratio low. It will also help to demonstrate length of credit history, which makes up 15 – 20% of your score.
Improved payment history.
Consistent and on-time payments are an important factor for improving your credit score. Debt consolidation reduces the number of monthly bills you owe, so it can help you avoid a late or missed payment.
How can debt consolidation hurt your credit?
People typically focus on the beneficial aspects and positive results of debt consolidation. But it’s also important to keep in mind there are some potential short-term risks and costs to consolidating your debt that you’ll want to take into account.
Credit inquiries.
When you apply for a debt consolidation loan or balance transfer credit card, the issuer or lender looks at your credit file. This could either mean a soft inquiry or a hard inquiry, but the latter can actually leave its mark on your credit report.
One or two credit checks will likely have a minimal impact, but multiple credit checks in a short amount of time can lower your credit score. This is why it’s essential to limit your number of new account applications and choose your options wisely.
Overusing credit.
Don’t be tempted to use up your newly-freed credit card balances once you’ve moved them. It creates a bad personal finance habit and it can lead to higher debt and a potentially lower credit score.
Also, if you pursue a balance transfer credit card, you will likely want to avoid any new purchases on it. Once a new purchase is made on a credit card that has a promotional balance transfer APR, the portion of your payment that would have been applied towards your debt is now reduced and applied to your new purchase, instead.
Age of credit.
Did you know that opening a new loan can reduce the average age of all your other credit accounts? This can result in a temporary dip in your credit score. However, it’s good to know the negative impact on your credit score will fade over time as you maintain the new credit accounts and continue making timely payments.
Monitoring your credit during debt consolidation.
Monitoring your credit is always a good idea, but that’s especially true when you’re consolidating debt. Regularly check your credit reports for accuracy to understand the impact on your financial situation. Take advantage of free credit monitoring tools and services to stay informed and make adjustments as needed.
Ways to consolidate debt.
Now that you know some of the benefits and risks, here are several debt consolidation options that you might want to take into account, each with its own set of advantages and considerations.
Balance transfer credit card.
A balance transfer credit card allows you to move high-interest credit card balances to a new card with a lower interest rate, often with an introductory 0% annual percentage rate (APR). This can provide significant savings if you pay off the balance within the promotional period. However, be mindful of balance transfer fees and ensure you have a repayment plan in place.
Debt consolidation loan.
Debt consolidation loans are personal loans designed specifically for borrowers wanting to consolidate their debt. They typically offer fixed interest rates and set repayment terms, making it easier to budget for with a fixed, predictable payment. If you’re shopping around for a debt consolidation loan, you’ll want to compare loan terms, interest rates, and fees before committing to a loan.
Best practices for consolidating debt.
To maximize the benefits of debt consolidation and protect your credit score, you might also want to put some of these best practices to work:
Create a payment plan. It’s important to have a clear debt management plan when it comes to debt consolidation. Consider creating an outline of your monthly payments, repayment timelines and any additional payments you can make to pay the debt off faster. Stick to the plan to avoid falling back into debt.
Sign up for autopay. Setting up automatic payments ensures you never miss a payment or make a late payment. These are both key factors for maintaining a positive payment history. Most lenders offer autopay options, and often these come with incentives such as reduced interest rates or lower fees.
Don’t take on more debt. Resist the temptation to use your newly available credit lines. Focus on paying off your consolidated debt and avoiding any new debt. Maintaining a level of discipline when it comes to spending will help you achieve financial freedom faster and protect your credit score.
Compare terms. Not all debt consolidation solutions are created equal. Compare interest rates, fees, repayment terms and other conditions to find the best option for your financial situation. Taking the time to research can save you money and ensure you choose the right solution for you.
Get help from a professional. If you’re unsure about the best approach to debt consolidation, consider scheduling a consultation with a certified credit counseling professional or fiduciary financial advisor. These professionals can provide personalized advice and help you develop a strategy tailored to your needs and goals.
The bottom line.
Managing or paying down your debt is always a good idea for your financial wellbeing. And debt consolidation can be a powerful tool once you’ve taken steps to educate yourself on the considerations and potential risks. Making informed decisions that benefit your financial health and credit history are key to attaining excellent credit.
Taking proactive steps and leveraging your resources to learn about debt consolidation and its impacts on your personal credit will put you in a good position to make the right decisions for you — and your overall credit health.
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