Understanding How Debt Consolidation Affects Credit Score
Updated: September 11, 2022
It’s common knowledge that eliminating debt usually results in an improvement of both your credit score and financial situation. To eradicate it, we use what resources we have available. If you possess a significant amount of debt, you may be considering debt consolidation. After all, it sounds like a sensible way to get a handle on your finances. Unfortunately, the way that debt consolidation affects credit score is not fully explained before you sign up. By the time you see if debt consolidation will ruin your credit score, it may already be too late.
How Debt Consolidation Works
Debt consolidation works in the following manner. A consumer in financial distress contacts a debt consolidation company. They discuss the consumer’s financial situation, including any debt that they hold. Both of them formulate a plan to eliminate debt by taking out a debt consolidation loan over 2-5 years. This new loan is expected to cover the cost of the consumer’s bills.
Debt consolidation companies claim to provide a few benefits. For one, you have less payments to make per month, and therefore not as many deadlines to juggle. You also have to deal with a smaller number of creditors contacting you for payment. The interest rate for your new loan may be lower than your previous rate. Your monthly payment could be lower than the total of your previously unconsolidated payments.
There are disadvantages. Not every creditor may want to accept a lower payment, and their debt obligation will be excluded from consolidation. You will either have to try negotiating with them yourself or paying as originally agreed. It is easy to misuse the credit that has now become available and run up high balances again. Remember that low interest rate? Well, you may still end up paying more in interest over the length of the debt consolidation loan.
How Debt Consolidation Can Improve Your Credit Score
It is rare, but possible, for debt consolidation to help your credit score. Debt consolidation can help you make payments on time for all of your monthly bills. Recall that payment history is worth 35% of your score. Selecting debt consolidation can influence more than 1/3 of your credit score.
The amount of credit that you are using compared to your total credit limit is called your credit utilization ratio. In general, you want this ratio to be 30% or less since percentages higher than this make lenders nervous. Consolidation can be used to pay down your credit card balance so that your utilization falls within this range. Your utilization ratio directly affects 30% of your credit score. Combined with your payment history, you can control 65% of your credit score with debt consolidation.
There are other situations where debt consolidation may make sense. When your only accounts are revolving credit card, it can benefit you to consolidate this with an installment loan. This could be a personal loan. The diversification of debt affects an additional 10% of your score. Debt consolidation is helpful when you have dealt with the root cause of the original debt. This increases the likelihood that you will successfully pay down your balance and keep it low.
How Debt Consolidation Ruins Your Credit Score
All too often, debt consolidation harms, not helps, your credit score. Missing one payment will result in a steep decline (recall payment history’s weight on your score). Do not use the debt consolidation period to apply for multiple credit offers. Chances are you will not qualify, and this will ding your score even more. Opening new accounts is worth 10% of your score, a much smaller part than payment history or utilization.
Your utilization will be hurt in a number of ways. Concentrating multiple credit card balances onto one credit card can easily exceed your credit limit. This blows up your credit utilization, and now you’ve negatively affected 30% of your credit score. Some debt consolidation companies may require that you close credit lines as part of a debt management plan. Closing these will reduce the total amount of credit available to you across all accounts, detracting from your utilization. Another action that may damage your credit utilization is adding fresh debt onto recently cleared cards. If you can pay off the balance by the end of the billing period, it’s not a problem. Otherwise, your utilization begins to rise again.
Think Twice before Consolidating Your Debt
If you are able to use debt consolidation to achieve your financial goals, then it makes sense to consolidate debt. Some reasonable goals include reducing your interest rate or moving to a lower monthly payment. Ultimately, your goal is to have a high credit score. In the short term, you may choose actions that will lower your score to save money through lower interest payments. There may be the additional benefit of paying off the loan faster this way. The payoff is that the consequences of debt consolidation last at least a year longer than the process itself.
Even if your goal is achievable, you may want to reconsider using debt consolidation. It’s not a good idea to let your credit score take a dive before making a large purchase. You may want to wait until after to consolidate your debt. If financial life is in shambles, this is not the time to use debt consolidation either. You are more likely to take on more debt in this state of affairs. It’s advised that you wait until you have managed your financial state better before using this service.
Consider Debt Consolidation Alternatives
If debt consolidation is sounding like it’s less of a good option for you, here are a few more solid options to try.
- Make your own get-out-of-debt plan (and stick to it). With a little bit of research and effort, you can design a custom-made plan to eliminate your credit card debt. We have a number of credit card calculators available to help you develop a way forward. You can calculate how much you can save, how long it will take to pay, and your total monthly payment. Using this information, you can create a monthly budget to help keep you on track.
You can also combine this with a number of ways to pay off debt. Two of the most popular methods are the snowball method and the high interest method. With the snowball method, you pay off the smallest debts first, gaining momentum to tackle the big debts. It’s popular because you tend to zero out more debt balances faster than other methods. The high interest method has you applying payments to the debt with the biggest interest rate first. As you eliminate the high interest rates, your debt becomes less expensive. Soon you’ll be left with the debt that has the lowest rates.
- Negotiate directly with your creditor. Some creditors are more flexible if you work with them without getting a third party involved. Give them a call and explain your situation to them. They may have a hardship program for borrowers for which you can qualify. In some cases, the program may be free.
- See if Chapter 7 bankruptcy is right for you. Some experts believe that Chapter 7 bankruptcy offers a better way to reset your financial situation than debt consolidation. There are some immediate shocks to your credit score, but it may be cheaper than other methods. It is also resolved faster, with most Chapter 7 proceedings being completed within 3-6 months. Upon completion of the bankruptcy process, you can immediately begin repairing your credit.
- Other loan alternatives (if you qualify). There are a number of other loans you may be able to use. Be cautious if taking out a loan to pay off another loan, since you are increasing your debt obligation.
A home equity loan/line of credit/second mortgage uses the equity in your home as collateral for a new loan. You will get better rates but will require a FICO credit score of 660 or higher. If you are still paying your first mortgage, you will now have two of them. Fall behind on these payments and your house is in jeopardy.
Cash-out refinancing works similarly to a home equity loan, but you only have one payment to one lender. You refinance your current mortgage and have access to up to 80% of the home’s value in cash. The credit score you need to qualify is 620 or higher. Like the home equity loan, your house is on the line if you fail to meet the payments.
Another option is a balance transfer credit card. You may transfer your debt to a card with a low or 0% APR. This APR is temporary, and you are advised to pay off your debt before the deadline. Failing to do so will cause rates that are determined by your credit score to be applied to the card.
Two things we don’t recommend at all are debt settlement and credit counseling. Despite being advertised as better solutions than bankruptcy, they are much worse. The financial effects of these two actions can last up to 5 years. Worse, it takes another year to rebuild your credit before lenders will even consider doing business with you again.
Now you know how debt consolidation affects credit score. Can debt consolidation hurt your credit score? Yes, and the negative effects of it may devastate your financial foundation. Carefully and thoroughly reconsider whether debt consolidation is your best option to get you out of financial distress. You can get the same assistance from one or more alternatives that will damage your credit score less than debt consolidation.