How Debt Consolidation Affects Your Credit: Does it Hurt or Help?

I've been there — the desk swimming with bills, the calculator screaming that you don't have enough money, the headache you get deciding which bills you can pay late, and constant nausea resting in the pit of your stomach.

It's exhausting.

If you’re wondering how to pay off debt and make those stressors go away, you may have looked into combining some or all of your loans into one. That’s completely normal.

“Debt Stress” Can Affect Anyone

As a full-time freelancer, my monthly income often changes from month to month, and sometimes it's a bit hard to keep track of when my clients pay versus when the bills are due. My husband has a steady income, which helps. But, the time he had to have surgery for a hernia and missed a month of work, or that time I was so sick I could hardly move for a week, or the times we spent a little more than we had, really put our budget to the test.

I'd like to think we're pretty average. We have student loan debts, a car payment, and some credit cards we're paying off, and on more than one occasion when the paychecks have gotten a little cozy, we've researched some emergency plans to help free up a little extra cash.

How Debt Consolidation Affects Your Credit

If you're reading this, it's probably because you want to know if it's a good idea to consolidate your debt. The answer: maybe.

You’re probably also researching how something like this will affect your credit going forward. In this quick guide, I’ll cover the basics of exactly how your credit might be affected when consolidating debts, if debt consolidation loans will outright destroy your credit score, and the impact on debt consolidation on your credit.

How It Can HURT Your Credit

No beating around the bush, debt consolidation can hurt your credit, but you do have some control over how much an impact this debt payment tactic has on your score.

If done correctly, a debt consolidation loan or credit card refinancing will help more than it will hurt. However, at least initially, your credit score may take a hit, especially if you apply with multiple lenders over several months.

According to FICO, applying for a car loan or a mortgage with several companies within 45 days won't hurt your credit score because the reporting agencies view them as a single inquiry. Student loans also qualify because a lot of borrowers shop for different rates on these type of loans before committing.

However, if you apply for several credit cards and/or personal loans (which you would use for debt consolidation), your score could drop several points. Multiple applications for certain types of credit, particularly consumer credit, could flag you as a higher risk, which is why your score could go down.

Your credit score could also be negatively affected if you use debt consolidation to pay off your bills and then start spending on your credit cards again. Not only will this negatively impact your credit score, but you could also end up even deeper in debt — something you should try to avoid at all costs.

How It Can HELP Your Credit

While debt consolidation can initially make your score dip (all new credit may drop your score a few points), in the long-term, your credit score may actually go up. The reasoning for this is when you consolidate your debt into one payment, you're freeing up money on accounts where you already have established credit, which affects your credit utilization score.

Quick Example

Let's say you have three credit cards:

• Credit card 1 has a limit of $5,000, and you have a balance of $3,500
  
• Credit card 2 has a limit of $3,000 and you have a balance of $2,000
  
• Credit card 3 has a limit of $1,500 and you have a balance of $1,500
  

Your total credit limit is $9,500 and you've spent $7,000. You are using 73 percent of your available credit. Your credit utilization makes up 30 percent of your total credit score, so keeping the number low — ideally around 35 percent or less — can help raise your score.

Taking out a debt consolidation loan actually increases the amount of available credit. So, if you took out a loan for $7,000, you now have $16,500 of available credit. Assuming you use all of the money to pay off your current balances and don't spend any more on your credit cards, your new credit utilization would be just over 42 percent.

Another benefit of consolidating debt payments is you may be able to get a better interest rate. Credit cards can have interest rates up to 36%, and payday loans are even worse, with some companies charging upwards of 600% (yes, really). Choosing to consolidate your loans at a much lower rate can save you money and make it easier to pay off your debt over time, which is good for your credit score.

Should You Consolidate Loans To Improve Your Credit Score?

Debt consolidation loans can be very helpful. Not only do they simplify monthly expenses (it's easier to keep track of one bill than five), you may be able to save money every month, which in turn, can help boost your credit score.

Consolidating Loans Helped Our Credit Scores

My husband and I consolidated our credit card bills last year using a personal loan from our local credit union. When we were paying each card separately, our total in minimum payments was just over $350. With our personal loan, which we used to pay off all of the credit cards, our monthly payment is $215. By consolidating our payments with a personal loan, we were able to free up more than $100 per month for other expenses.

So, for us, consolidating our debt made sense and is helping us maintain and improve our credit.

However, if you're considering whether or not using personal loans to consolidate debt is a good idea, there's one additional factor I'd also urge you to consider before moving forward (and it's a big one). You'll have to get really honest with yourself. 

If you pay off all of your credit cards using a debt consolidation loan, are you going to pull out the cards and start spending again? You can easily double or even triple the amount of debt you have if you don't have the discipline necessary to stop using your credit cards until the consolidation is paid off.

There are definite benefits to debt consolidation, but if you can't trust yourself to cut spending habits, you may just end up in deeper trouble.

When Should You Consider Using a Balance Transfer Card Instead?

Using a balance transfer card has major benefits if you have the discipline to back it up.

Some of the best balance transfer cards offer promotional terms of 0% interest for a set amount of time. You transfer your balance from one card to another and then begin paying off your debt on the second card. With a 0% interest rate, every dollar you put toward paying your bill helps pay down the amount you owe. You can pay off a fair amount of debt quickly using a balance transfer card instead of a debt consolidation loan.

Balance Transfer Card Example

Let's say you have a credit card with a balance of $3,500 and a 24% APR. You would have to pay $185 per month for 25 months to pay off the balance. If you get a card with 0% APR and pay $190 per month you could have the total paid off in 18 months.

The biggest condition here is that you'll need a good credit score to qualify for the best terms. It can still be a viable option with a less than ideal credit score, but you may not qualify for the longer interest-free periods.

What about debt settlement — Does that affect my credit?

Debt settlement does indeed affect your credit score and it can happen in a big way, depending on how you handle the decision. Apart from bankruptcy, debt settlement typically has the biggest potential to negatively impact your credit score.

When you settle a debt, it usually means you aren't paying the full amount you owe. You may settle with individual lenders or creditors, or work through a professional provider to do so. Either way, you may be required to close your credit cards, which will immediately affect your credit score since your amount of available credit will drop, impacting your credit utilization.

Your reduced payment will go on your credit report, which can drop your credit score as it shows you haven’t paid the full amount. However, if you can settle with the lender before they send it to collections, the impact may be less extreme than if you ignore the bill and wait for the debt collectors to come calling. (Remember, once they do, you still have rights in place).

Debt consolidation is a better option for your credit score, by far, if you qualify for it.

If, however, you don't qualify for debt consolidation loans, you can't afford to pay your bills, and you want to avoid bankruptcy, debt settlement could be a viable option.

Given How Debt Consolidation Affects Credit, is it a Good Idea?

Now that you know how debt consolidation may affect your credit, you’re in a better position to understand if it’s a good idea for paying off your debt.

The bottom line is, consolidating loans can be a great method when used properly. You can free up a little extra money every month to put toward other expenses, simplify your monthly budget, and potentially get out of debt faster than you thought.

While your credit score may initially drop, the long-term effects can be quite positive if you continue making payments on time and commit to not taking on any additional debt. That being said, if you do start spending money on cards you’ve paid off, you could harm your credit score and land in deeper debt.

Debt consolidation is the double-edged sword of debt repayment plans. There are both pros and cons to weigh when considering it. You have to decide whether you can put your cards away until you've paid off the balance on your debt consolidation. If not, you may be better off paying each bill separately. Take the time to understand how consolidating loans affects each component of your finances and you’ll be in a good position for repaying your debt.