How Does Debt Consolidation Affect Your Credit Score?

Debt consolidation can lower your monthly payments, but can it also lower your credit score?

Well… it depends.

In some cases, debt consolidation will get you a better interest rate, simplify your paydown process, and put you on the fast track to being debt-free. But in others, you’ll get nothing for your trouble except a ding to your credit.

To help you decide if debt consolidation is right for you, we’ve broken down exactly what it means, when it makes the most sense, and how it impacts your credit score.

What is Debt Consolidation?

Debt consolidation is a technique that combines multiple debt payments into a single monthly payment with better repayment terms.

Usually, that includes:

  • A lower interest rate: Most importantly, debt consolidation should lower your average interest rate. Don’t equate this with a lower monthly payment though, since the payment can be manipulated by the length of the new loan. 
  • Fewer payments to keep track of: Dealing with multiple lenders and tracking multiple monthly payments makes it much more likely that one will slip through the cracks, delaying your repayment and damaging your credit score.
  • A more flexible payment schedule: Debt consolidation can help you avoid early payoff charges and even pause your interest accrual, allowing you to pay down your debts aggressively.

How Can You Consolidate Your Debt?

There are two general debt consolidation strategies:

  1. Low-interest loans: Use the proceeds from a personal loan to pay off all your previous lenders, then pay back the new (and cheaper) debt in fixed monthly installments.
  2. Balance-transfer credit cards: Transfer all your outstanding debts to the balance transfer card and pay off everything during the initial 0% interest period.

Here’s a simple example to show you how this might work:

Let’s say you have three credit cards, each with a $2,000 balance. They have annual interest rates of 15%, 20%, and 25% respectively.

If you made no payments and incurred no new charges, you’d rack up a whopping $3,031 in interest over the next two years (see for yourself).

But if you consolidated that debt into a balance transfer card, you could pause your interest for that same period and pay off your entire debt with just $250 a month.

Can Debt Consolidation Hurt Your Credit Score?

In the short-term, debt consolidation can hurt your score by a few points. To explain why, here’s a chart with a breakdown of the five factors that make up your credit score:

Debt consolidation will reduce your score at first because it adds another hard inquiry (or credit check) to your history.

That happens any time you apply for new debt, and you’ll have to apply for either a consolidation loan or a balance transfer card to execute the strategy. If you’re approved for a new loan or credit card, the average age of your credit will go down slightly too.

The good news is that both of these categories each make up only 10% of your score, so the effect won’t be too noticeable. Although, this goes to show that debt consolidation has its limitations.

The Limitations of Debt Consolidation (And When it Doesn’t Work)

Beyond potentially dinging your credit score, sometimes debt consolidation just doesn’t make sense. Here’s when it probably won’t be able to work for you:

  • You Have a High Debt-to-Income Ratio: If your debt balance is simply too high to cover with your current income, debt consolidation probably isn’t going to solve your problems. While reducing your interest rate will help lower your payment somewhat, consolidation loans and balance transfer cards require you to start aggressively paying down your debt. If you can’t afford it, the consolidation will backfire.
  • You’re Caught in the Vicious Cycle: To qualify for a consolidation loan or a balance transfer card, your credit needs to be above a certain level. If your debt problem is so big that your credit score has fallen below 580, it’s going to be difficult to consolidate.
  • Your Spending Habits are Poor: Debt consolidation only works if you subsequently follow through and pay off your new debt. If you have poor spending habits and don’t fix the problem that caused you to get into debt in the first place, you’ll just end up back where you started.

Can Debt Consolidation Help Your Credit Score?

In the long-term, a properly executed debt consolidation will only boost your credit.

While the initial inquiry and new account may hurt your score by a few points, the consolidation will naturally improve the consistency of your payments and reduce the amount of your debt over time.

Those two factors combined account for 65% of your credit score, so even a minor improvement can easily make up for any damage done to your credit early on.

The Benefits of Debt Consolidation (And When it Works Best)

Debt consolidation might not be a magic solution for everyone, but it’s a popular tool for good reason. Here are the situations where it will benefit you the most: 

  • You Lower Your Rates and Monthly Payments: Above all, debt consolidation works best when you have multiple high-interest accounts. If you can consolidate to a loan with less interest and a smaller monthly payment, you can supercharge your debt paydown. 
  • Your Credit Score is (At Least) Fair: Debt consolidation is intended for individuals who are struggling with debt, so it wouldn’t make sense if it was only available to those with the best credit. Fortunately, the cutoff is usually around 600, which is an achievable credit score even if you’ve made some mistakes.
  • You Get a Simplified Repayment Plan: For some individuals, the hardest part of managing your debt is just that – managing and making the payments. If you have a half dozen or more monthly payments to keep track of, debt consolidation can save you from ever missing one and damaging your credit score further.

Types of Debts You Can Consolidate

Fortunately, debt consolidation can work with all types of debt, including:

But you don’t necessarily have to consolidate all of your debts. If one account already has favorable terms, you can take a consolidation loan out and use it to pay off a select few.

For example, let’s imagine you currently hold a mix of credit card debt, payday loans, and student loans.

Credit card rates average around 18% APR, payday loans average around 400% APR, and student loans average around just 6% APR. 

If you get a consolidation loan with a rate of 7%, you can (and should) use it only to pay off the credit cards and payday loans, leaving the student debt alone.

What if You Don’t Qualify for a Debt Consolidation Loan?

If you’re unable to qualify for a debt consolidation loan because of your credit score, don’t panic. There are still options available to you.

First, shop around a little. Some lenders may be more or less willing to extend you a loan.

Second, do everything you can to improve your credit score. Get a free credit report and look for any errors. Cut back on your spending and focus on paying back your debt.

Third, consider getting expert help. If your situation feels unmanageable, DebtHammer can get you the support you need.

We’ll thoroughly analyze your debts, put together an achievable plan to tackle them and serve as a middleman between you and your lender. Take advantage of our free consultation and we’ll get your debt under control.

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