How Does Debt Consolidation Affect Your Credit Score?

What Is Debt Consolidation?

Debt consolidation Is the act of taking out a loan to pay down unsecured debt, such as credit card debt. For example, if you have several credit cards with high balances on them, a debt consolidation loan will give you money that you can use to pay off your credit cards. So, instead of having several credit card payments to worry about, you’re essentially combining all of your debt into a single manageable payment. People often choose consolidation loans because they offer favorable Interest rates and lower monthly payments. That said, It Is Important to note that consolidation loans do not erase the debt, but merely transfer It to a different lender for you to continue paying off. So, how do consolidation loans affect your credit score? We will discuss this in much detail below.

How Does Debt Consolidation Affect Your Credit Score?

Debt consolidation can either help your credit score or hurt It depending on what you do after consolidating your debt. For. If you take out a consolidation loan and use It to pay off your credit cards, you will help your credit score so long as you make timely payments on your loan and don’t use your credit cards to rack up more debt.

Debt consolidation can have a positive effect on your credit score because It reduces the amount of credit that you’re utilizing. For example, if you have a credit card with a $15,000 credit limit and you pay it down from $10,000 to $2,000, your are reducing your credit utilization from 67% to 13%, which will definitely help your credit score.

As a rule of thumb, you should always strive to keep your credit utilization below 30%. Stay below 30% and this factor will have a positive Impact on your credit score.

Also, a consolidation loan can help your credit score because It creates a better credit mix. A consolidation loan will appear on your credit report as an Installment account, which creates a better mix of credit, which can help your credit score.

So long as you don’t accumulate more debt on the credit cards that you have paid off with your consolidation loan, making timely payments on your loan and paying down the balance will definitely affect your credit score In a positive way.

However, debt consolidation can have a negative effect on your credit score. For example, if you take out the consolidation loan to pay off your credit cards and then rack up new debt on your credit cards, this will hurt you because you already have a large balance on the personal loan you took out to consolidate your debt, and now you’re utilizing more of you’re available credit, which tends to lower your credit score.

Also, if you take out a consolidation loan and fail to make on-time payments on the loan, the loan will have a negative Impact on your credit score. Before applying for a consolidation loans, check the requirements for the loans because applying for too many loans to consolidate your loan can actually hurt your credit score. This Is so because every time you apply for a loan, a hard Inquiry Is placed on your credit report. Too many hard Inquiries within a short period of time can negatively affect your credit score.

Summary of How Debt Consolidation Affects Your Credit Score

Pros of Debt Consolidation (advantages)

  • Lower debt payments
  • Lower interest rate
  • Can help you pay down balances more quickly
  • Helps improve your credit mix
  • Simplifies making payments since it combines your debt into one manageable payment (payment of the debt in one place)
  • Can improve your credit score because it reduces your credit utilization

Cons of Debt Consolidation (disadvantages)

  • If you use the credit cards you’ve paid off, debt consolidation can lead to more debt, so you have to be disciplined to actually pay down your debt and not accumulate new debt
  • If you fail to make consolidation loan payments, you can damage your credit
  • Some consolidation loans have high fees and interest rates making them difficult to repay
  • Paying more interest in the long run
  • Applying for too many loans within a short period of time can hurt your credit score

How Can You Consolidate Your Debt?

Here are a few ways that you can consolidate your debt.

1) Personal Loan

The most popular way to consolidate your debt to take out a personal loan with a low Interest rate and use that loan to pay off high Interest rate debt, such as credit card debt. After paying off your high Interest debt, you will only need to pay back the fixed term personal loan.

2) Balance Transfer Credit Card

A second way to consolidate your debt is to apply for a balance transfer credit card with an introductory 0% APR. If your application is approved, you can transfer the balance from your high APR credit card to the balance transfer credit card and pay down your balance without paying interest on the balance during the introductory period. The benefit of a balance transfer card is that you typically have an introductory period where you aren’t charged any interest. This period usually lasts for 12 to 24 months. After that, you’re charged interest on the money that you owe.

3) Home Equity Loan

The third way to consolidate your debt is to take out a home loan, using your home as collateral, and using the money to pay off your credit cards. Home equity loans almost always have a lower interest rate than credit cards. However, be careful when taking them out. If you do not repay the loan, you risk losing your home.

When Should You Consolidate Your Debt?

As a rule of thumb, you should consolidate your debt when your total debt exceeds 40% of your gross income (excluding your mortgage). It’s also a good idea to consolidate your debt If you have a good credit score and are able to qualify for a low-Interest rate personal loan. When consolidating your debt, you should have a repayment plan in mind. Although It may be tempting to borrow money on credit cards that you’ve paid off, you should avoid doing this to prevent falling into too much debt all over again.

Here Is an example of when you should consolidate your debt. Let’s say you have a credit card with a 17.99% to 24.99% Interest rate, and you have good enough credit that qualifies you for a personal loan at a 6% Interest rate, you should then take out that personal loan to pay off your unsecured credit card debt.

That said, if you have a small amount of debt, such as $8,000 or $10,000, you should not bother with debt consolidation, you’re better off trying to pay It off on your own without taking a loan to do so. Behave yourself and cut down on spending for a few months and pay off your debt on your own schedule.

Debt consolidation loans if used properly can be a great tool to help you in paying off debt. However, you should keep in mind that you’re paying off debt with debt, so after you take out a loan and pay down your debt, don’t accumulate new debt.

Does Debt Consolidation Erase Your Debt?

No, debt consolidation does erase your debt. Debt consolidation usually occurs when a person combines debt from several creditors by taking out a single loan to repay all of the debt at a lower interest rate on a fixed schedule. The main goal for debt consolidation is to reduce the amount of time it takes to repay your debt and making repayment more manageable by only worrying about a single payment.

Debt Consolidation vs Debt Settlement

As previously mentioned, debt consolidation works by consolidating some or all of your debts into a single loan. The debtor still owes the debts and is still responsible for paying it. The only thing that changes is that the debt is shifted from one creditor to another. Debt settlement, on the other hand, involves negotiating with a creditor to settle the debt for less than what you owe. For example, if you owe a creditor $7,000, you might offer the creditor a lump sum of $4,000 to settle the debt. The creditor then has the option of accepting the settlement or rejecting it. So, there is a difference between debt consolidation and debt settlement. If you owe money to more than one creditor, you must go through this process with each and every creditor. A settlement with one creditor does not bind other creditors.

Credit Score Planet Frequently Asked Questions

1) How does debt consolidation affect your credit?

If used properly, debt consolidation can affect your credit score in a positive manner. For example, it will decrease your credit utilization. If you pay on time you’ll have an installment loan account that in good standing, which will help your credit score. Also, since a consolidation loan will appear as an installment account on your credit report, it will create a better credit mix for you, which affects your credit score in a positive manner.

2) What are the pros and cons of debt consolidation?

  • Pros of Debt Consolidation
    • Lower debt payment
    • Lower interest rate
    • More manageable debt payments
    • Improved credit mix
  • Cons of Debt Consolidation
    • If mismanaged, you will accrue more debt than you started with
    • If you fail to make timely payments, you will damage your credit
    • Payment of more interest in the long run

3) Is it a good idea to consolidate your debt?

If you have a high amount of debt, it may be a good idea to consolidate your debt. To determine whether a debt consolidation loan is right for you, you should contact a financial advisor in your own jurisdiction because everyone has a different financial situation that should be examined prior to consolidating your debt.

4) What are the advantages of debt consolidation?

You can find the advantages of debt consolidation in the section above titled “pros of debt consolidation.”

5) What are the risks of debt consolidation?

The risk of debt consolidation is defaulting on your debt consolidation loan or racking up new debt on accounts that you have consolidated.

6) Can You get debt consolidation with poor credit?

It is very difficult to get debt consolidation with poor credit because you’re applying for a loan or seeking a balance transfer credit card, two things which are often only given to those with good credit or fair credit. So, if you’re credit score is too low, you might not qualify for a debt consolidation loan or balance transfer credit card.