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With large numbers of American households accruing high balances on credit cards and loans, finding creative solutions to repaying debt is critical. One option when you owe money to many creditors is a strategy known as debt consolidation. By consolidating your debt, you can organize your accounts in one place and often benefit from a lower-interest window in which to begin paying your balances. However, debt consolidation is not without its drawbacks.
Debt consolidation can hurt your credit score temporarily, though there are ways to minimize the effects. Debt consolidation is the process of taking multiple loans and refinancing them into one loan with a new lender. There are multiple ways to consolidate your loans. The most popular way is to take out a personal loan and use those proceeds to pay off your other debts, but some consumers prefer to use home equity loans or HELOCs.
No matter which type of loan you choose, the process is largely the same. When consolidating debt, your credit is checked, which can lower your credit score. Consolidating multiple accounts into one loan can also lower your credit utilization ratio, which can also hurt your score. However, making the choice to consolidate your debt into one manageable payment will improve your credit score over the long term. Payment history is 35 percent of your credit score, so making on-time payments will increase your score.
If you only have revolving credit like credit cards, adding in a personal loan for debt consolidation can improve your credit mix and also boost your score. Taking out a debt consolidation loan can either positively or negatively impact your credit, depending on a few factors.
When you apply for a debt consolidation loan, the lender will perform a credit check. This will result in a hard inquiry, which could lower your credit score by 10 points. Hard inquiries will only affect your credit score for one year. If you have a large balance on a credit card, you may also have a high credit utilization ratio. This is calculated by dividing your current card balance by your total credit limit.
If you have a credit utilization ratio greater than 10 percent, you may see a ding on your credit score. However, if you pay off that balance with a personal loan, the utilization percentage will drop and your credit score will improve.
The average age of your credit accounts makes up 15 percent of your credit score, with a higher age being better for your score. When you open a new account, the average age of your credit history will decrease. If you close any old accounts after consolidating, that will also lower the average age of your accounts. Thankfully, there are strategies to get around this. If you have old credit cards with high interest rates, you consolidate that debt using a new card with a lower interest rate.
You might be wondering if consolidation hurts your credit. It turns out that the answer is a mixed bag. Some aspects of debt consolidation can hurt your credit score slightly in the short-term. Other aspects could cause positive changes to your credit score over the medium- and long-term.
It really boils down to the specifics of your situation and how you manage your debt after consolidation. First, debt consolidation involves opening a new loan or line of credit i. This will involve at least one new credit inquiry and lower the average age of your accounts, which can create a short-term drop in your score. One tip is to do your research first. As Experian points out, by knowing your credit score in advance and researching the loans or credit cards available, you can limit the number of inquiries , protecting your score.
However, if you use a consolidation loan and you have not had a loan before, this could have a favorable impact on your credit mix, since you would then have credit cards and a loan on your file.
The greater impacts to your score will come from payment history and amounts owed, since they are the two most heavily weighted categories of your credit score. What matters more is your credit utilization. This is a ratio of how much credit you are using total balance to how much you have available total credit limit. A high utilization can hurt your score. This may also negatively affect your chances of getting credit in the future.
Knowledge Centre Debt Management How does debt consolidation work? What is debt consolidation? The benefits of debt consolidation loans Debt consolidation may also allow you to take advantage of lower interest rates , by switching higher interest loans into one lower rate loan. Having an easily-manageable payment can help you safeguard your credit score , as you may minimise your chances of missing a repayment.
The challenges of debt consolidation loans You could end up paying a higher rate of interest on your debt consolidation loan. If it has a longer term, you may also pay more overall.
Depending on the size of your original debt, you may end up taking out a consolidation loan which is larger than all of your combined debts.
You may have to pay hidden or extra fees to clear your existing debts. What is an unsecured debt consolidation loan? What is a secured debt consolidation loan?
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