How Does Debt Consolidation Affect Your Credit Score?
Debt consolidation can help you simplify your financial life and potentially save on interest. It can affect your credit score in a few different ways.
May 18, 2022
If you have multiple loans or credit card balances, it could be worth considering debt consolidation. This may benefit you by:
Reducing the number of bills you need to pay each month
Potentially lower your interest expenses
But before pursuing debt consolidation, it’s important to understand how it works. There are a variety of options available, and each could affect your monthly finances and your credit rating.
How does debt consolidation affect your credit score? We’ll explore this topic after covering the basics.
What is debt consolidation?
Debt consolidation is the process of combining multiple debts into one. In most cases, this involves taking out a large loan to pay off all other debts, thereby “consolidating” all those debts into one new loan.
Debt consolidation is generally worthwhile when it can help you save money on interest. For example, consolidating credit card debt into a personal loan may help you lower the interest rate you pay.
Plus, consolidating simplifies your financial situation and reduces the number of monthly bills you need to pay.
How does debt consolidation work?
There are a few different ways to consolidate debt:
Credit card balance transfers: You can transfer balances to one credit card (hopefully, a lower interest rate). Remember that balance transfer fees can be high (often 3 to 5% of the amount transferred).
Personal loans: You can apply for a personal loan and use that money to pay off any existing debts. You’ll be left with just a single personal loan and one monthly payment.
Home equity loan (or HELOC): If you own a home, another option is to use a home equity loan or a home equity line of credit. You borrow against the value of your home and then use that money to pay off existing debts.
Line of credit: You can also use a specialized line of credit designed to pay off high-interest debt.
The general process is to take out a new loan, use the funds to pay off existing debt and continue making monthly payments toward the new loan. This changes the type of debt you hold and could alter your credit rating.
So, how does debt consolidation affect your credit score?
How does debt consolidation affect your credit score?
Consolidating debt can immediately impact your credit score — for better or worse. As long as you responsibly manage your debt, potential negative effects are likely temporary.
Depending on the details, consolidating debt can improve or worsen your credit score. The most common possibilities are outlined below.
When does debt consolidation hurt your credit score?
There are a few main ways that debt consolidation could potentially lower your credit score short-term:
Opening a new account: If you open a new loan or transfer the balance of your credit card(s) to consolidate, this new account will lower your average age of accounts. This is a significant credit ranking factor, although the extent of the effect depends on how many accounts you have and how old they are.
A new credit inquiry: Each time a lender pulls your credit report, it’s reported as a credit inquiry to the main credit bureaus. A hard inquiry can reduce your score by a few points, but this drops off after 12 months (and is usually fairly minor).
Higher credit utilization: Credit utilization refers to the percentage of available credit you are actively using. If you use a balance transfer credit card to consolidate debt, you may have a higher credit utilization on that card. This can have a temporary negative effect on your credit rating.
Most of these effects are temporary as long as you responsibly manage your new loan and complete the required monthly payments.
When does debt consolidation improve your credit score?
There are also a few ways in which debt consolidation can help boost your credit score:
Lower credit utilization: Transferring a balance to a card with a higher credit limit could decrease your credit utilization and boost your score. For example, if you have a $3,000 balance on a card with a $4,000 limit, you are utilizing 75% of the available credit. If you transfer that $3,000 balance to a card with a $10,000 limit, now you’re only utilizing 30% of the available credit.
On-time payments: Making regular, on-time debt payments is one of the most important factors that go into building a positive credit history. If you stay on top of your debt payments, that can boost your score.
Debt consolidation can potentially help improve your overall financial situation, which should make it easier for you to successfully manage your debt payments. Over time, this can significantly improve your credit and your overall finances.
The answer to “How does debt consolidation affect your credit score?” depends on several factors.
Ultimately, the effects on your credit shouldn’t be a major concern; as long as you responsibly manage your debt, the effects will be temporary.
Whether or not debt consolidation is worthwhile depends on what options are available. Potential savings in interest is a primary consideration — any side effects to your credit score shouldn’t greatly influence your decision.