Does Debt Consolidation Hurt Your Credit?
Matt Cardwell6-Minute Read
UPDATED: July 26, 2023
If you’re facing debt, you’re surely not alone. A Bankrate 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 payments 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 impact debt consolidation has on your credit score.
Will Debt Consolidation Hurt My Credit?
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’s also important to understand the effects it can have on your credit score. The last thing you want is to endure bad credit, just because you’re actually trying to improve it.
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.
To fully understand the impact that debt consolidation can have on your credit score, it’s important to first understand how debt consolidation works.
How Does Debt Consolidation Work?
Essentially, debt consolidation is a type of debt refinancing where a person in debt takes out a new loan for an amount that covers several debts consolidated together (or, in the case of credit card debt, consolidating existing debt into a new, low interest balance transfer credit card – more on that below).
In doing so, the debtor has replaced multiple high-interest debts with one monthly payment, hopefully at a lower interest rate. This can make it easier for an individual to budget, and having a lower-interest rate can help you pay your debt off faster since more of your payment will go towards the principal than the interest.
If you’re hoping to consolidate and pay off your debt, you’ll likely use either a personal loan or a balance transfer card.
Debt Consolidation With A Personal Loan
With a personal loan, you’re essentially rolling all of 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 they’re all rolled into just one fixed monthly payment. This eliminates the possibility of forgetting to make a payment, and ultimately damaging your credit. This loan is paid down as an installment loan, where you have a defined term by which the entirety of the loan will be paid off by.
Debt Consolidation With A Balance Transfer Card
With a balance transfer card, your existing debt is moved onto a new credit card and you essentially start over with a "clean slate." However, this method can cost you an initial upfront cost, often 2% – 5% of your total balance for the credit card issuer to allow you to move your existing debt to this new card.
The benefit of a balance transfer is that you’ll 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 in interest going forward and won’t actually end up helping to save money in the long run.
How Debt Consolidation Can Affect Your Credit Score
Let's take a look at how some of the steps in the debt consolidation process can affect your score.
It Requires A Hard Inquiry Of Your Credit
Any time a lender checks your credit score with a hard inquiry the credit bureau will make note. The lender wants 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.
Debt consolidation loans require a hard pull of your credit, which can result in your score dropping as much as 10 points. 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. Thankfully, most hard inquiries will only stay on your credit report for two years.
You Have To Open A New Credit Account
Anytime you open a new credit account, it can lower your credit score since there’s still that "unknown" factor of whether you will responsibly pay it off. Plus, any new credit will also increase your debt-to-income ratio, which may make it harder to get approved for credit during the life of your loan or credit account.
Your Credit Utilization Could Decrease
When you have a significant balance on your credit card that is close to your overall credit limit, your credit utilization score is considered to be high. When you pay this balance off using a personal loan, your credit utilization rate will drop. This can have a positive effect of increasing your credit score.
A Reduced Credit History
Another effect on your credit score when consolidating your debt is the length of time you’ve had your accounts for. Whenever you open new credit accounts, it can draw down the 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 that you will only reap the benefits if you practice good financial habits with these new loan vehicles.
Should I Consolidate My Debt?
Debt consolidation can be beneficial for the right individual. Consolidating your debt could save you a significant amount of money in interest fees and help simplify your payments. However, debt consolidation is only a temporary solution. If you continue to rack up charges on your credit cards, your problem will only continue to grow.
Be sure to talk to a financial professional who can help you decide if debt consolidation is right for you. They will be able to assist you in choosing the right option and provide you with tips to prevent you from falling back into debt.
Debt Consolidation Alternatives
If debt consolidation isn’t right for you, there are alternative solutions that you can use to help manage your debt.
Pay Off Your Debt On Your Own
If you are able to manage your monthly payments on your own still, consider setting a strict monthly budget. This strategy can help you evaluate your current income and expenses to see if you may be able to allocate any extra funds towards your debt. Consider trying a new way of tackling your debt such as the snowball or avalanche method.
Use A Debt Management Plan
If your debt is making you feel overwhelmed and you feel like you need assistance, you may want to consider enrolling in a debt management plan. With these plans, you make one monthly payment to a nonprofit credit counseling agency instead of a direct lender payment. They will then make your payments on behalf of you.
File For Bankruptcy
If you’re unable to continue making payments, are unable to get approved for a debt consolidation loan and have exhausted all of your other options, you may need to consider filing for bankruptcy. With bankruptcy, you can legally file to wipe out some or all of your debts. However, it’s important to know that your bankruptcy will remain on your credit report for 7 – 10 years and can make it difficult for you to apply for financing in the future.
Consider Debt Settlement
If you’ve tried other solutions, but are still struggling to manage your debts, you may consider debt settlement. However, this should be used as a last resort option. With debt settlement, you negotiate with creditors to settle your debts for less than what you currently owe. This can either be negotiated by yourself or a professional debt settlement company. This method can be risky as not all creditors will accept your negotiated settlement and it can have adverse consequences on your credit.
Final Thoughts: Is Debt Consolidation Right For You?
If you’re concerned about protecting your credit score for the long term, debt consolidation may help you get where you want to go, as long as you continue to stick to your budget and pay off what you owe, even if you might take a hit on your credit history in the meantime.
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. If you’re ready, start your personal loan application with Rocket LoansSM today.
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