Does Debt Consolidation Help or Hurt Your Credit Score?

Oftentimes, people wind up with multiple types of debt—typically in the form of credit cards—with varying interest rates and varying amounts owed on each card. It can be difficult to keep track of the monthly payments and some wind up with more debt than they can handle. If you feel as though you're drowning in credit card debt and can't keep up, consolidating your debt could be key in getting your finances back on track.

Debt consolidation involves combining, or consolidating, all of your debts into one at the lowest interest rate possible. Not only does this make budgeting and paying your monthly debts easier, but it also allows you to pay off your debt faster with more of your payments going toward the actual debt rather than the interest.

Types of Debt Consolidation

Balance transfer.

People with good credit can normally go the DIY route when it comes to consolidating their debt. You can transfer your balances to a new account—typically through a lower-interest credit card with a high credit limit. Keep in mind, though, that there are normally transfer fees involved in moving balances from one form of debt to another.

Debt consolidation loan.

Debt consolidation loans were created for the primary purpose of consolidating your debt. There are two types—an unsecured debt consolidation loan, or personal loan, and a debt consolidation loan that is secured by the equity in your home, or a home equity loan. The advantage of a home equity loan is that since the loan is backed by your house, the interest rate is lower. However, either option will typically lower your interest rates and monthly payments.

Related: 6 Debt Consolidation Myths: Debunked!

How Consolidating Your Debt Affects Your Credit Score

In the short term, applying for a debt consolidation loan or a new credit card will not significantly affect your credit score, though your credit will take a small hit from the new inquiry.

In the long term, debt consolidation will have a positive impact on your credit score, assuming you pay all of your monthly payments on time. Credit agencies look at your credit history as a whole and will see that the other accounts have been paid off in full. Between paying off balances and making your new payments on time each month, you should start to see your credit score improving.

Once your old accounts are paid, it's best to leave them open rather than close the accounts. The reason for this is closing several accounts will reduce your total available credit and thus raise the percentage of your available credit that you're using, which can negatively impact your credit score. If you're tempted to spend by leaving the accounts open, you can cut up the credit card or store it in a place that's hard to access—such as a safety deposit box at your local bank.

It's important to note that you can adversely affect your credit rating if you turn to a debt management agency to negotiate a settlement with your creditors for less than you owe. This goes on your record as a failure to repay what you've promised. Some credit agencies might also allow your accounts to go unpaid for months before they settle, which will also lower your credit score.

Overall, though, consolidating your debt will improve your credit score as long as you make your monthly payments on time and avoid racking up more debt.

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