It is incredibly easy to become overwhelmed by your debt situation. Maybe you have too many accounts. Maybe you have too many different types of credit and loans. Maybe you have too much credit card debt or are stuck with student loans. Maybe your payments are too high and your income is too low. However you got here; debt consolidation might just be the best way to get out.
What is Debt Consolidation?
Let’s pretend you have three credit cards, each carrying a balance. To simplify things, you take out a loan from the bank and use that money to pay off all three of your cards. That’s debt consolidation. It is the act of consolidating multiple debts into a single debt (and then working to pay that off).
Does Debt Consolidation Affect My Credit Score?
One of the first questions people as is “does debt consolidation hurt your credit?” Yes, it does, but here’s the good news: that damage is only temporary! Over time as you work to pay down your consolidated debt, your score will recover and will probably get even better than it was before you decided to consolidate. Here’s the lowdown on how that process plays out.
How Debt Consolidation Helps Your Credit
There are two main ways that debt consolidation can improve your credit: by improving your payment history and lowering your ratio of credit available vs. credit used. Let’s look at each of them.
Improved Payment History
It is vital that, after consolidation, you make your monthly payment on time each month. On-time repayment is very important. Over time, you will build up a positive payment history, which will help grow your score.
Lower Credit Utilization Ratio
One of the biggest factors in your credit score is how much of your credit allotment is currently available. The closer you are to your credit limits, the lower your score will be.
If you keep your existing credit lines open after consolidation, those accounts will show a 0 balance with X dollars of credit available. Even with your consolidation loan factored in, your credit utilization ratio will still be much lower than it was when all your open accounts were maxed out.
If you work with a debt consolidation company, they will probably want to close all those accounts. This isn’t the very best way to go, score-wise, but it is usually the best option for helping you avoid temptation! Even if you do close your accounts, as you pay off the balance on your consolidation loan, the wider your credit utilization ratio will be. The wider the ratio, the higher the score!
How Debt Consolidation Hurts Your Credit
As mentioned earlier, unfortunately in the early stages of debt consolidation your credit score is going to take a hit. It might even take a pretty big hit. Here are some of the reasons that will happen:
New Credit Applications
If you are consolidating your debt yourself, you will likely be applying for a variety of different credit lines and loans until you are approved for something. While the act of applying for credit isn’t automatically dinged by the credit bureaus (that only happens if a hard pull is done), banks and creditors can still see those applications when they pull up your report (usually this is called a soft pull). The more credit inquiries that are on your report, the more desperate you seem, which makes you unattractive to lenders.
When you’re shopping around for a loan, it’s common for lenders to do a “soft” pull on your credit to verify your identity and make sure everything is on the up and up. They also use these “soft” pulls to give you an idea of whether you’ll qualify for a loan and what that loan’s terms will be. If you don’t like the offer, you can move on to the next potential lender.
Each time you fill out an application for new credit or for a loan, though, that company will do a “hard” pull on your credit. One “hard” pull will probably only ding your score by a point or two. If you have a lot of “hard” pulls, your credit score could drop by 10-20 (or more) points. So, make sure a loan is worth it before you fill out your application!
Closed Accounts, New Accounts, and the Average Age of Credit
When you work with a professional debt consolidation company, they will likely require you to close accounts as they are paid off. The more closed accounts you have in your credit history, the harder hit your score will be.
If you take out a loan or line of credit to use for consolidation, that new account will increase your available credit and lower the average age of the accounts on your report. Generally speaking, the older an in-good-standing account is, the better it looks to the credit bureaus.
Best Ways to Consolidate Debt
There are a bunch of ways to consolidate debt. Among the most popular are:
The one that works best for your situation is going to depend on a variety of factors like how much money you owe, how many creditors you have, your current credit score, your ability to pay back a loan, etc. You should also be honest with yourself during this process. For example, are you responsible enough to have open lines of credit and not use them? Do you have the time/energy to negotiate your balances with your creditors?
What is a Debt Consolidation Loan and How Does It Work?
A debt consolidation loan is exactly what it sounds like. It is a loan that you use to pay off your other debts so that everything you owe is consolidated into a single loan. A lot of different banks, financial companies, and credit unions offer them.
Using a Balance Transfer Credit Card Offer to Consolidate Debt
If your credit is still pretty good, one option that is available to you is to open a new credit card with an introductory 0% or low interest rate and then transfer the balances of your other cards and loans to that account. This option is especially attractive because credit card companies often offer deals on balance transfers. This can save hundreds or even thousands of dollars in interest, but you’ll have to pay a balance transfer fee that usually ranges from 3% to 5%. Citi, Discover, and U.S. Bank usually offer good deals. Bear in mind, though, that the low interest rate will only be valid for a set period of time. And if you don’t make on-time payments, the interest rate will shoot up.
However, if you’re having trouble with debt, opening new credit card accounts may not be the best solution. That can encourage more spending and accrue new debt.
Consolidating Debt with a Personal Loan
Personal loans or installment loans can be good options for people whose credit is in good standing. The best place to get one of these loans is through your current bank. Your existing relationship with them should work in your favor. Credit unions are another good option, especially if you are concerned about your interest rate.
You should be wary here, though: personal loan interest rates will depend on your creditworthiness. You could end up paying quite a lot in interest by the time your loan is paid off!
Other Ways to Consolidate Debt
There are, of course, other ways to consolidate debt. For example, homeowners have the option of a home equity loan or home equity line of credit (sometimes known as a HELOC) might be an option. If you’ve been paying off your mortgage for several years and have some equity built up, this might be a good time to consider a mortgage refinance. Another option could be to take a loan out from your 401(k) or IRA. Be careful here, though! The penalties for defaulting on these types of loans are steep.
Pros and Cons of Consolidating Your Debts
Outside of the impact on your credit score, there are other pros and cons associated with consolidating your debt.
On the pro side, having just one payment to make each month on the new loan is much easier than having to make several. It’s easier to plan and budget for. One payment also means that you’ll only be paying one interest rate, and won’t have to worry as much about fees for late payments. These factors alone could save you hundreds of dollars by the time your loan is paid off.
On the con side, particularly in the short term, debt consolidation can have a massive negative effect on your credit score. Yes, if you’re diligent you can help that score rebound and even rise. Can you afford to take that hit right now, though?
When Does It Make Sense to Consolidate Your Debts?
This is going to be different for each borrower. Think about your situation — are you constantly forgetting payments each month because you have too many to make? Consolidation could be the answer. Do you want to really attack your debt so that you can save for a big purchase like a new home? Consolidating your debt could help you do that.
On the other hand, if you just want to pay a lower interest rate on the accounts you currently have, you might be better off simply contacting each creditor and re-negotiating your rate.
Smart Strategies for Debt Relief
Start with a list. Write down every debt you have. Assess your credit mix. For each debt, tally the following:
- Total amount due
- Interest rate
- Minimum payment each month
- Number of payments left to make
- Make a choice! Learn about which debt consolidation methods most interest you. Research providers by getting quotes from each company you want to work with. Pay attention to the loan terms. Go with the provider who offers the best quote.
Note: To avoid hard inquiries wreaking havoc on your score, apply for each potential loan within the same two-week period.
Make sure you maintain good credit. Start by checking your credit report from each of the three major bureaus (Experian, TransUnion, Equifax). You can get a free credit report each year at annualcreditreport.com. Make sure that it is mistake-free to ensure that your FICO score is as high as possible. Sign up for a service that regularly sends you a free credit score. From here on out, make your monthly payments on time so that your score will continue to grow!
The Bottom Line
Personal finance is just that — personal. Debt consolidation might not be for you. If you’re having trouble finding a good loan or plan, here are a couple of alternatives available:
- Work with a professional to create a debt management plan.
- Overhaul your budget
- Consult a credit counselor. Credit counseling can help you sort out your types of debt and help you set up a manageable debt payment plan.
- Explore debt settlement.
If you’re considering debt settlement, watch this to learn the pros and cons:
What’s important is that you stick with the plan to get your budget, spending, and your debt under control. Don’t give up!