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How Does Debt Consolidation Affect Your Credit Score?
By Bianca Rodríguez Rojas MONEY RESEARCH COLLECTIVE
Debt consolidation is a form of debt repayment where you combine all your debts into one. Whether you use a balance transfer card or a debt consolidation loan, this debt-relief approach helps you streamline your payments into one monthly bill.
You can use debt consolidation to lower your credit utilization and improve your score. However, opening a new account or applying for a loan can temporarily lower your score. This is because when you open a new account it involves a hard credit inquiry and reduces your average credit age.
Read on to learn more about the effect of debt consolidation on your credit, as well as ways you can minimize its impact.
What is debt consolidation?
Debt consolidation is when you combine several of your debts into one manageable account. These debts can be credit card accounts, medical bills or personal loans. The goal is to simplify payments, preferably with a loan or credit card that has a lower interest rate. Doing so helps you simplify how you manage your debts, while helping you reduce the total interest you pay over time.
The most popular debt consolidation options are taking out a personal loan, using a balance transfer credit card or enrolling in a debt management plan. Bankruptcy is also an option, but its effects are more far reaching than with other methods.
While debt consolidation helps you repair your credit, note that credit repair itself involves identifying and disputing errors in your credit report.
How Debt Consolidation Impacts Your Credit Score
Debt consolidation can have both negative and positive effects on your credit score. Applying for a new credit or loan account involves a credit check which will lower your score temporarily. However, when you open a new account with a lower annual percentage rate it allows you to save on interest payments and reduce the overall cost of your debt.
Negative effects of debt consolidation
- Applying for a new loan – When you apply for a debt consolidation loan or credit card, lenders will run a hard inquiry on your credit report. These hard inquiries lower your credit score temporarily. While one hard inquiry may lower your score by less than five points, several hard inquiries in a short time span will increase the negative impact on your credit score. This is something to keep in mind when shopping around for the best rate.
- Opening a new account – When you open a new credit account it can lower the average age of your credit history. This age drop can slightly reduce your credit score because lenders and credit bureaus favor longer credit histories. (However, long credit histories are favorable if you’ve managed your credit responsibly.)
- Using a high amount of your credit – If you consolidate your debt into a single credit card and close all or most cards, your credit utilization ratio will likely increase. The credit utilization ratio is a key factor in the credit scoring models of major bureaus. A high utilization ratio can hurt your credit score in the short-term because it communicates to lenders that you may be over-reliant on credit, which can make you appear as a higher risk borrower.
Positive effects of debt consolidation
- Lower credit utilization – Debt consolidation can help you lower your credit utilization if you move high balances from multiple credit cards to a loan or a new card with a larger credit limit. As we mentioned above, credit utilization is a significant factor in credit scoring. Therefore, when you reduce the amount of available credit you’re using, your score can improve.
- On-time debt payments – When you consolidate debt into a single monthly payment it’s easier to make consistent, on-time payments. As you do so, your payment history — the most important factor in your credit score — can improve. This will increase your credit score over time.
Types of debt consolidation
Balance transfer
A balance transfer is when you move high-interest credit card debt to a new credit card that offers a 0% or low introductory interest rate for a limited time. This debt consolidation method allows you to not only save you money on interest, but also reduce debt faster. However, before you choose this option, consider the balance transfer fees and the expiration of the introductory rate of the new card to determine if it’s the best option for you.
Personal loan
You can use a personal loan to pay off high-interest debts using a product with fixed monthly payments. Personal loans often have lower interest rates than credit cards, which could help you reduce the total cost of the debt over time. If you consolidate your debts with a personal loan, you’ll know exactly when the debt will be paid off.
Home equity loans or HELOCs
Home equity loans or Home Equity Lines of Credit (also known as HELOCs) allow you to tap into your home’s equity to pay off other debts. Since these loans are secured by your home, they typically offer lower interest rates compared to unsecured loans. However, this is a high-risk form of debt consolidation because your home could be at risk if you fail to make payments.
401 (k) loan
A 401(k) loan allows you to borrow against your retirement savings to consolidate debts. While this option offers low or no interest and doesn’t affect your credit score, it comes with significant risks. This is because you may face taxes and penalties if you leave your job or fail to repay the loan. It also undermines your retirement savings, making it especially risky if this is your only retirement account.
How to minimize the impact of debt consolidation
If you choose to consolidate your debts, here are four tips to help you minimize the impact on your credit score and stay on track with your repayment plan:
- Stop using your credit cards: Avoid taking on new debt while you focus on paying off the consolidated balance. This not only keeps your credit utilization ratio low, but it also keeps your payment at a consistent level while you pay down debts.
- Pay your bills on time: Consistent, on-time payments are crucial for improving your credit score as major credit bureaus (Experian, Equifax and Transunion) view recent credit history as more important than older.
- Keep credit lines open whenever possible: Leaving credit accounts open, even with zero balances, helps maintain a low credit utilization ratio. As we’ve mentioned, this helps you improve and keep a good credit score.
Avoid opening new accounts for a while: After consolidating, don’t apply for new credit to avoid further hard inquiries and to give your credit score time to recover.