How Does Debt Consolidation Affect Your Credit?
For many people battling debt like credit card bills, medical bills, and student loans, debt consolidation is an effective way to reduce monthly payments, lower interest costs and ultimately get debt-free faster. Only having to make one monthly payment is also super convenient.
There are multiple options for debt consolidation (more on this in a bit), but if you stick to a well-thought-out payoff plan, a new lower-interest loan is a viable way to pay off high-interest balances in one shot.
But this approach has drawbacks. For example, one common question about the tactic is, “Does debt consolidation hurt your credit score?” The answer is yes and no. Let’s start with the negatives.
How debt consolidation can hurt your credit score
When taking out a consolidation loan, you may see an initial dip in your credit score because applying for a loan generally results in a hard inquiry into your credit report.
“The degree to which they have a negative impact depends on how many inquiries you have over a specific period of time,” says Bruce McClary, spokesperson for the National Foundation for Credit Counseling. “If you only apply for one loan and you get approved and you get that loan, that inquiry is going to have a minor impact on your credit score; barely noticeable.”
He adds: “But if you’re shopping around and you apply for a loan with four or five different lenders, those four or five different inquiries are going to show up in the process, and that could have a bigger negative impact on your credit report.”
According to FICO, the main credit score company in the U.S., how much a hard inquiry hurts a credit score varies from person to person, and such an inquiry is more likely to hurt your credit score if you have few accounts or a minimal credit history. In other words, research your options in advance to avoid potential credit damage from applying for multiple debt consolidation loans, or ask for loan quotes based on soft credit pulls, as opposed to hard inquiries.
Another common mistake that can take a toll on your credit score is if you pay off on your consolidation loan. If you close the credit cards you pay off, you reduce your available credit, which could increase your credit utilization ratio (a.k.a. the percentage of available credit you’re using) and lower the average age of your credit history. Those two factors — amounts owed and length of credit history — make up a huge chunk of your credit score. It may be to the benefit of your credit score to leave open your credit card accounts, particularly the oldest ones.
Another way your credit could suffer from debt consolidation is if you work with an agency to implement a debt management plan (DMP). These plans often require closing your credit card accounts, and if the debt management or credit counseling agency negotiates lower settlements on your behalf, those accounts may be reported to the credit bureaus as “not paid as agreed.” That can hurt your credit score. However, these plans are for people who are already struggling with severe debt, so paying off your debt this way is likely to have a positive long-term effect on your credit that outweighs any short-term damage.
How debt consolidation can help your credit score
On the flip side, debt consolidation can majorly help your credit score. You may be able to get a consolidation loan with an interest rate lower than what you’re paying across all your separate debts, which means more of your monthly payment will go toward your principal balance.
Improving your credit score after consolidating debt isn’t as tricky as you might think either. In fact, you can improve your credit as you repay your consolidation loan.
While your credit score may take a small hit during the loan application process, reducing your debt burden and lowering your credit utilization ratio can do wonders for your score in the long term — especially if you’re able to accelerate your progress by paying more than the minimum payment whenever possible.
“Your payment history is 35 percent of your overall credit score, based on the FICO model, so by simply paying that account on time and not missing any payments is going to help boost your credit score,” says McClary.
This goes for all your accounts, not just a debt consolidation loan. Another critical piece of the puzzle is actually using credit. This probably seems counter-intuitive, but charging a handful of monthly transactions, then paying them off in full at the end of each billing cycle, shows that you’re able to handle your credit. A simple way to do this is to use a credit card to cover some regular monthly expenses that you’re planning on paying in full anyway — like gas, groceries or your cell phone bill. If you use a rewards card, you can also snag some points in the process. Paying the balance in full means you won’t accrue interest on those purchases, so you can avoid the debt problems that led you to consolidate in the first place.
“Over time, your credit score could be helped because you’re eliminating a lot of debt that you’ve had trouble paying off, so it’s freeing up available credit and indicating that you’re becoming less and less burdened by the debt that you owe,” says McClary.
Just know that boosting your credit score isn’t an overnight process. While there are a lot of moving parts, and every case is different, McClary says that it typically takes about six months for your credit score to start rebounding after a consolidation.
Ways to consolidate debt to raise a credit score
Debt consolidation loans take more than one form. Here are four financing options to make crossing the debt-free finish line a little easier.
A balance transfer lets you take all your credit card balances and lump them into one new credit card with either a lower ongoing annual percentage rate (APR) or a lower introductory APR for a specific period. This can ultimately help you get out of debt faster while paying less in the long run.
Let’s pretend your credit card balances look something like this:
- Card 1: $1,000 balance with an 18 percent APR; paying $100 per month.
- Card 2: $1,000 balance with a 6 percent APR; paying $100 per month.
- Card 3: $500 balance with a 10 percent APR; paying $50 per month.
Plugging these numbers into a debt payoff calculator reveals that you’ll pay a total of $2,644 and get out of debt in 11 months. But if you transfer these balances onto a new credit card with a 0 percent APR and no balance transfer fee, and continue paying the same amount each month, you’ll pay $144 less and get out of debt in just ten months.
The higher the interest rates are on your existing debt, the more you’re likely to save with a balance transfer, but there’s a catch: When the promotional interest rate expires, you’ll probably get slammed with a high ongoing APR. To get the most out of a balance transfer, pay off your balance before the promotional period ends. Promo periods can last from six to 24 months. Credit card companies also usually charge a one-time transfer fee of up to 5 percent of the balance, so be sure to read the fine print, do the math and have a payoff plan in place before pulling the trigger.
A personal loan is another common way to consolidate. Once you’re approved, the lender deposits the money into your bank account, letting you pay off all your balances at once.
These types of loans come with fixed rates and fixed payments, along with a clear payback timeline. Of course, the interest rate you get can be a deal breaker, so shopping around and comparing offers from multiple lenders is your best strategy. (Again, the whole point is to transfer high-interest balances to a lower-interest loan.) On a similar note, folks with spotty credit should look long and hard at the terms they’re offered; interest rates can exceed 35 percent for applicants with bad credit.
Pro tip: Limit your search to lenders that use soft credit pulls. This way, getting a variety of quotes won’t show up on your credit report and indirectly impact your credit score. You can find and compare loan offers on LendingTree — we use a soft credit pull to search for loans that may suit you.
Home equity loans
Homeowners have an additional consolidation option: taking out a home equity loan (HEL) or home equity line of credit (HELOC). Similar to a personal loan, a home equity loan translates to a chunk of money you can use to pay all your debts and with the proceeds of a new, fixed-rate loan. The amount of equity you have in your home will in part dictate how much you can borrow, but qualifying criteria varies from lender to lender.
The more equity you have, the better terms you’ll get. Locking down the best rate typically means that your mortgage debt doesn’t exceed 85 percent of your home’s value. Your debt-to-income ratio (DTI) also comes into play. If your total debt payments equal more than 45 percent of your total income, lenders may be hesitant to give you a HEL.
That said, home equity loans can be a fantastic consolidation tool. If you can secure a lower interest rate, you’ll ultimately pay less over the long haul. On top of that, wiping out your debts will also reduce your credit utilization ratio, which should give your credit score a boost. Just be sure your budget allows you to easily absorb the new monthly loan payment — because you’re using your home as collateral, defaulting on a HEL could result in losing your home.
Home equity lines of credit have risks and rewards similar to home equity loans. Because HELOCs are secured by your home, they tend to have lower interest rates than credit cards, but that also means you could lose your home if you can’t make payments. However, unlike home equity loans, HELOCs have variable interest rates and have a flexible repayment structure.
Borrowing money from an employer-sponsored retirement fund is another way to consolidate unwanted debt, but you’ll want to think long and hard before doing it. The IRS doesn’t mess around when it comes time to repay the money you borrow from a tax-advantaged retirement account — you generally have five years to repay the loan and must make payments at least quarterly, otherwise you’ll be subject to a 10 percent early distribution tax (if you’re younger than 59 ½). (Remember, your 401(k) contributions have the effect of reducing your taxable income.)
You may also have to pay the tax if you leave the employer sponsoring your 401(k) or if the loan exceeds the maximum amount of 50 percent of your vested account balance or $50,000, whichever is less. Another thing to consider is that borrowing money from your future self-means you’re ultimately missing out on investment returns you could have earned if you didn’t touch the money.
You’ll have to check your 401(k) plan for interest rate information, as each plan has its own rules, but the prime rate plus one percentage point is a common interest rate.
You can learn more about each individual option to consolidate debt and weight the pro’s and con’s here.
Should I consolidate my debt to better my credit score?
The decision to consolidate debt is a personal one, but there are a few general rules of thumb to help make the choice a little easier. Consolidating your debt should represent an actionable get-out-of-debt strategy — not a means of delaying the inevitable. Transferring debt from one account to another, without a real plan for paying it off, isn’t going to ease your debt burden or improve your credit score over the long haul.
Another key piece of advice is to really look at the terms of your consolidation loan before going through with it. If you’re not getting a better interest rate or lower monthly payments than you have with the original debt, what good will it do you in the big picture, aside from giving you one monthly payment? The bottom line is securing a consolidation plan that helps you save money will get you out of debt faster but if done correctly, can also help raise your credit score in the process.