Does Debt Consolidation Hurt Your Credit Score?
If you’re facing debt, you’re surely not alone. A CreditCards.com report finds that nearly half of U.S. adults have credit card debt. Add in other obligations you might have in your credit mix, from student loans to your mortgage or auto loans, and your monthly bills can quickly start to pile up.
That’s where debt consolidation can come in as a great option for helping manage your monthly payment and potentially earn you a lower interest rate than you are currently paying. But consolidating your debts also means that you are taking on new debt – at least temporarily – which can impact your credit score. So when you weigh the pros and cons, is it the right solution for you?
In short, it depends. Let’s find out what you need to know about debt consolidation, particularly as it relates to your credit score.
What Is Consolidated Debt?
First, let’s define what we mean when we discuss “debt consolidation.” There are two main ways to approach it: one is through a debt consolidation loan, also known as a personal loan, where you take all your balances and convert them into one new loan. The other is by using a balance transfer credit card, where you take existing credit card balances and put them onto a new card.
The reason someone would consider one of these methods is to help make their current debt more manageable. First, it can allow you to streamline your bills; rather than having multiple balances, you’re able to consolidate them into one payment. And depending on your credit score, you might even be able to qualify for a lower interest rate, which means you might be paying less overall in the long run.
Whether you choose a personal loan or a balance transfer card, you want to pay close attention to the interest rate. To come out ahead, the personal loan will need a lower interest rate than you currently have, and the balance transfer card should have a low promotional rate – ideally zero – so you can take advantage of interest rate savings.
In addition, before taking on either one of these debt consolidation vehicles, you will want to make sure that you find out all the fees that might be involved in either choice. Again, the strategies are only helpful if you are coming out ahead, and fees that are too high can have the opposite effect.
How Does Consolidated Credit Work?
As mentioned, if you’re hoping to consolidate and pay off your debt, you’ll likely use one of those two strategies. Here is some more about both of them.
Debt Consolidation (Personal Loan)
With a personal loan, you are essentially rolling all your current debts into one, new loan. While it might seem like a backwards solution to take out yet another loan, the bonus of a debt consolidation loan is that instead of making multiple payments (and possibly forgetting to make one … which can damage your credit) you will be putting them all into one fixed monthly loan.
If you go this route, rather than having multiple credit card balances of various amounts, you will have one payment that’s the same every month. And, you’ll be paying it down, in what is known as an “installment loan,” where you have a defined term by which it will all be paid off.
That is in contrast to the concept of a credit card and “revolving credit,” where you may be making additional charges even while you are trying to pay it your existing balance. When the balance keeps rising, it can feel frustrating and as though you will never reach the bottom. The satisfaction of watching your balance dwindle via a debt consolation loan can be very gratifying.
Balance Transfer Card
To use this debt consolidation tool, you’ll be taking your existing debt and putting it on a new credit card – thereby essentially starting with a “clean slate.” However, this method can cost you an initial upfront cost, often 2% to 5% of your total balance in order for the credit card issuer to allow you to move your existing debt to this new card.
The benefit of this strategy is that you will be choosing a zero-interest credit card – one with an introductory offer that provides you with the chance to make interest-free charges and payments, as long as you pay off the balance within the defined promotional time, often a year.
Remember that this method can be risky; while the promotional time period offers you a leg up, once it is over, you are likely going to be facing a much higher interest rate. If you were unable to pay off your debt in the time you had anticipated, you might owe a lot of money of interest going forward and won’t actually end up helping to save money in the long run.
What Does Debt Consolidation Do To Your Credit Score?
While consolidating your debt can be a wise strategy to make your debt more manageable – and possibly earn you a lower interest rate provided you qualify for an appealing offer – it is also important to understand the effects it can have on your credit. The last thing you want is to endure bad credit, just because you are actually trying to improve it.
Your credit score, or FICO® Score, is the number that lenders use to determine if you are a good credit risk. The higher the credit score, the lower the risk you appear to be. That can result in a lower interest rate because they expect you will pay your debts back in a responsible fashion. (Wondering how you rate? Find out more about getting your free credit score at our sister company, RocketHQSM.)
But every action you take with your credit can have a consequence, and that includes debt consolidation tools. While your credit will take an initial hit, it will likely be positively impacted over time, so long as you keep up with your payments. Fortunately the long-term benefits can far outweigh any short-term negatives as you burnish your credit by paying close attention to paying off these debts. But it’s important to keep these three considerations in mind for how debt consolidation can potentially hurt your credit score:
A “Hard Pull” On Your Credit
Any time a lender pulls your credit score, it is known as a hard inquiry, and the credit bureau will make note. The reason is that they want to make sure you aren’t possibly amassing more credit than you can reasonably handle. After all, just because you’re merely shopping around and seeing if you qualify, they don’t know if you might actually be using all the credit that you are being offered.
That’s why it’s smart to do your research and know more about whether you want to pursue this path prior to having a lender pull your credit.
A New Credit Account
Anytime you open a new credit account, it can lower your credit score since there is still that “unknown” factor of whether you will responsibly pay it off.
A Reduced Credit History
Another factor in your credit score is how long you have had your accounts. So whenever you open new credit accounts, it can draw down your average of your older accounts. However, your FICO® Score will still take into account the age of your oldest account, so make sure not to cancel it right away.
While there will be long-term upsides to your credit, remember, you will only reap the benefits if you practice good personal finance hygiene with these new loan vehicles.
Four Steps To Successful Debt Relief
There are four main rules you should follow as you pay off your debt in order to ensure that any potential damage to your credit score is minimal.
1. Make Your Payments On Time
You’ve likely heard that on-time payments are a key factor in how high your credit score is. In fact, even having one miss on your payment history can mar your credit. That’s why it’s vital to make sure you always make your debt payments on time.
Fortunately, it can be easier than ever to keep up on your bills when you use a debt consolidation strategy like a personal loan or a balance card transfer. That’s because rather than having multiple monthly payments, as you likely had before, you’ll only have one monthly payment to keep track of.
2. Don’t Run Up Your Cards
Once you move the balances to either a personal loan or a new credit card, you want to make sure that you don’t fall back into old habits and put more debt on your former cards and then just make the minimum payments. If you run up the credit card balances again, you can find yourself in even more potential credit trouble – not only are you responsible for your new debt consolidation vehicle, but you also will have to manage your new payments. Any good you might have done by streamlining your bill paying and converting to one manageable payment can be lost if you revert to using your old cards.
Now you might be wondering if you should cancel those credit cards you’re no longer using. The short answer is no. That’s because, as mentioned above, another important component of your credit score is your “credit history,” or how long you have held credit. So even if you’re not using those older credit cards, it’s wise to keep the credit card accounts open to show longevity. You might even put an occasional bill on it, such as using it when you’re filling up your gas tank so that the credit card issuer doesn’t cancel it. Just remember to pay it off in full – and definitely don’t be late with the payment
3. Don’t Make A Mistake With Your Timing
This guideline is particularly important should you choose to use a balance transfer credit card. Remember the reason it’s an attractive vehicle to consolidate your debt is because it comes with a low introductory rate that will allow you to pay off your debt with as low of an interest rate as possible.
However, once you get out of that promotional period, your rate can zoom. If you haven’t paid off your debt in time, you’ll be stuck paying it off at this much higher rate, which can harm your finances as well as your credit score.
4. Watch Your Credit Utilization
Another factor that goes into our credit score is your credit utilization, or how much of your existing credit you are using at any given time. Ideally your credit utilization ratio is about 30%, which means that you keep your credit card balance at 30% or less of your limit.
So that means if your card has a $1,000 credit limit, ideally you don’t have more than $300 on the card at any one time. Of course, that can be tricky if you are putting a large sum on the balance transfer card. Talk to your credit card issuer about whether you might temporarily have the ceiling lifted in order to preserve your credit utilization ratio.
Is This The Right Debt Management Plan For You?
If you’re wary of protecting your credit score – which is admirable for your financial future – you might be wondering if debt consolidation is a good avenue for you, considering that it might create a temporary drop. But this method of debt relief could bring multiple benefits in the future. These include finally managing your debt and clearing up your credit accounts, as well as the peace of mind that comes from debt relief.
If you’re unsure of the best next step, one option is to consult with a credit counselor to find out more about how debt consolidation could affect you. But no matter what avenue you choose, becoming debt-free by making changes to your spending and debt management will feel fantastic.
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