How Does Debt Consolidation Affect Your Credit Score?
If you're facing hefty debt, consolidation could bring some relief, such as a single monthly payment and a lower interest rate. But consolidating your debt can also impact your credit score — for the better and for the worse. It all depends on how you approach the consolidation process.
Before you decide to move forward with debt consolidation, here are some basics about how it works, potential impacts on your credit score, and how to maximize the upside.
What is debt consolidation?
Debt consolidation is simply combining two or more debts into a single monthly payment. Debts such as credit cards, high-interest debts (like auto loans or retail finance accounts), private student loans, and medical bills can all be consolidated into a single loan with one monthly payment.
People consolidate their debts for different reasons, but some of the most popular are:
- Simplicity: A single monthly payment can be easier to manage than several.
- Savings: Consolidation at a lower interest rate can save you money in the long term.
- Speed: A consolidated payment at a lower interest rate can make it easier to pay off your debts faster by freeing up extra money you can put towards debt repayment.
What are the different types of debt consolidation?
Debt consolidation comes in several different flavors, depending on the type of debt. Some of the most common ways to consolidate debt are:
- Credit cards: You can choose a new or existing credit card with an attractive balance transfer offer and move your existing credit card debt there.
- Debt consolidation loans: If you qualify, a personal loan with an interest rate lower than that of your existing debt can provide cost savings.
- Home equity lines of credit (HELOCs): Homeowners can use the equity in their home to consolidate debt at a lower interest rate than many credit cards.
- Student loan consolidation programs: These programs can combine multiple student loans into a single payment, often at a lower interest rate.
How can debt consolidation help my credit score?
Depending on how you choose to consolidate, your credit score may experience a positive bump. Here's how consolidating could improve your score, based on how credit scores are calculated.
- Lower your credit utilization: Credit utilization (the percentage of your total available credit that you're using) accounts for 30% of your credit score. The less credit you're using of your total available credit, the better your credit score will be. Opening a new account (a credit card or consolidation loan) increases your available credit while your total debt remains the same. This can increase your score because you're now using less of your available credit.
- Lead to faster debt payoff: Since less debt means lower credit utilization, paying down your debt faster helps you to increase your credit score faster. Here's how debt consolidation can help with that: If your total monthly payment goes down as a result of a lower interest rate, you can afford to pay more than the minimum on your consolidated debt each month. If you do this, you'll pay off your debt more quickly than you would've without consolidating.
- Reduce or eliminate late payments: A good payment history accounts for 35% of your credit score. Debt consolidation can help you achieve this goal in two ways. First, the more bills you have to juggle, the more likely you are to let something slip through the cracks. And second, by reducing the total amount you owe every month (due to a lower overall interest rate), you also reduce the chances that you lack the funds to make your monthly payment.
Instead of closing old credit cards after consolidating debt, cut them up. That way they're still contributing to your overall available credit.
How can debt consolidation hurt my credit score?
While there's a definite upside to the ease of a single payment and the temptation of a lower interest rate, consolidation can hurt your credit score in a few ways. But some simple strategies can help minimize the impact.
- New credit inquiries: Each time you apply for a loan or a credit card, you'll incur a hard inquiry on your credit report. Since credit score inquiries and new accounts contribute to roughly 10% of your credit score,1 several inquiries and new credit accounts in a short period can lead to a drop. To minimize the impact, check your credit score2 in advance, so you can confirm with the lender or card issuer that your credit score is sufficient for the loan or credit card you want. And then apply for just one loan or card for your debt consolidation.
- Increased credit utilization: If you use a new loan or credit card to consolidate and then close the credit lines you've rolled into the new debt, you could decrease your available credit and thereby increase your credit utilization. A better choice: Instead of closing credit cards, cut up those that you've moved your debt out of. That way, you won't be tempted to use them, but they're still in your name and contributing to your overall available credit.
- Lower age of credit: New accounts can lower the average age of your credit accounts. Credit history length accounts for roughly 15% of your overall credit score. This is another reason why keeping unused credit card accounts open after consolidation is so important.
What are some predatory consolidation practices to watch out for?
Be cautious of companies that charge a monthly fee to "manage" your debt and negotiate with your creditors. Any service that a so-called debt consolidation company can offer you (lowering your payments or negotiating a payoff) is also accessible directly by you. All you have to do is reach out to your creditors and start the conversation. While it might take a bit of back and forth, you might find you can get a lower interest rate or even an attractive balance transfer offer just by calling.
Debt consolidation can help you achieve a lower monthly payment and a lower interest rate for all your existing debt. And you don't have to pay a fee to anyone to help you do this.
Important disclosure information
This content is general in nature and does not constitute legal, tax, accounting, financial or investment advice. You are encouraged to consult with competent legal, tax, accounting, financial or investment professionals based on your specific circumstances. We do not make any warranties as to accuracy or completeness of this information, do not endorse any third-party companies, products, or services described here, and take no liability for your use of this information.
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