Debt consolidation means paying off multiple accounts with higher interest rates and replacing them with a loan with better terms -- preferably a low fixed interest rate and a single monthly payment. To achieve this, you might choose a home equity loan, a personal loan, a balance transfer credit card or another scheme. But what should you do about the old accounts once their balances are "zeroed out?" To protect your credit score, should you close them, or keep them?
Then, there's the opposite viewpoint. Closing out those accounts can cause your credit scores to drop, perhaps substantially. That's because closing accounts increases your credit utilization ratio, which comprises 30 percent of your score, according to MyFICO.com. Say, for example, that you have credit lines totaling $9,000, and you owe a total of $6,000 on these accounts. Your credit utilization ratio is $6,000 used / $9,000 available, which is .67, or 67 percent. Ideally, you'd like this ratio to be 30 percent or lower.
When you consolidate your debt, you're adding another account into the mix, and it changes your ratio this way:
- New account ($6,000) plus old accounts ($9,000) = $15,000 available credit.
- Amount of credit used is still $6,000, because you've replaced the credit card debt with the consolidation loan.
- $6,000 (used) / $15,000 (available) = .40, or 40 percent.
Consolidating your debt has caused your utilization ratio to drop, which could increase your credit score. Now, look what happens if you close the old accounts.
- Total available credit drops to $6,000 once you close $9,000in credit lines.
- And your balance is also $6,000. That's a utilization ratio of 100 percent, which could drop your credit score.
But wait, there's more.
The average age of your accounts impacts15 percent of your score. The older your accounts, the better your score. Suppose the $9,000 credit lines you have are ten years old. Then, you open the new account. Here's how that affects the average age of your accounts:
The average age of your accounts drops from ten years to six, because 40 percent of your debt now has an age of zero years. And if you close out the old accounts? Your average age drops to zero!
And that's STILL not all. New credit, including opening accounts or having multiple inquiries on your report affects ten percent of your score. Opening a new account almost always lowers your score a few points, temporarily.
So, with 30 percent of your score being credit utilization, ten percent being new accounts and 15 percent being average age of accounts, this transaction could affect 55 percent of your FICO!
So, after looking at what could happen to your credit scores, it seems as though leaving the accounts open is a no-brainer, right? Not necessarily. Notice that consolidating debt doesn't reduce it at all — you've just REPLACED your old debt with a different kind of loan. And that's where people have problems with debt consolidation — they see those zero balances and feel as though they've accomplished something, when they still owe the money.
Did you know that between 75 and 85 percent of those who consolidate their debts fail to pay them off? Those open and unused lines of credit are just too tempting for most folks. That's why financial advisers often recommend closing these accounts to prevent borrowers from re-using their credit cards once their balances have been zeroed out. This is what happens to most people who consolidate debt and leave their accounts open -- we'll continue to use the same example:
- Available credit increases from $9,000 to $15,000 ($6,000 balance on consolidation loan).
- At first, utilization drops to 40 percent because credit card balances are zeroed out.
- Then, balances creep back until credit cards are maxed out again and the total owed is now $15,000.
- Utilization increases to 100 percent.
- Credit scores drop, cost of new credit increases or credit becomes unavailable.
- Ability to repay is compromised as payments rise.
- Credit score drops much more if payments are late.
If you have plans to buy or refinance a home or make another large purchase on credit, protect your score after debt consolidation by leaving your accounts open. However, as soon as you've taken care of that big-ticket item, consider closing out your old accounts. If you don't plan any major financial moves, close them out as soon as you consolidate.
Think about it: if the reason that you need to consolidate debt in the first place is that you're prone to overspending, leaving those accounts open could be a disaster. While pulling back and closing your accounts could help instill better debt management habits, which in the long run will help you get and maintain a much better credit score.