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

I know debt can feel overwhelming. When your desk is covered in bills and you have to make decisions about which bills you can pay (and which ones you can’t), it’s uncomfortable and scary. Debt consolidation may be a solution — but will that impact your credit?

You know that paying off debt is key to reducing financial stress and moving forward with other big life goals, but it may feel impossible to get there. If you’re stressed about how to pay off debt, combining some or all of your loans into a single payment can help.

What is debt consolidation?

Among strategies for how to pay off debt, you’ll hear of debt consolidation. If you have multiple loans or credit card balances that are all due at different times each month and have varying interest rates, you might consider consolidating your debts. What this means is moving those debts into a new loan, so that you only have one monthly payment at one rate.

There are a few ways to essentially combine your debts, though it’s pretty common to take out a personal loan for debt consolidation.

Pros of debt consolidation:

• Can make monthly payments more affordable
• Simplifies debt repayment (one monthly payment)
• May lower interest rate to save money

I like the idea of debt consolidation because it simplifies your repayment process. Instead of managing multiple separate loans (with differing rates and due dates), you can make one payment each month and stay on top of your debt.

If you have a decent credit score, consolidation can also help you by lowering your interest rate. And another option is to negotiate the terms of the loan so that your monthly payments are more affordable. You won’t pay the debt down faster in this case, but you’ll make steady payments and improve your credit.

Cons of debt consolidation:

• Not as beneficial if your credit is poor
• Temporary drop in credit score
• Fees for the new loan

The benefits of debt consolidation can outweigh the downsides, so look at your particular situation to decide. Let’s focus on how debt consolidation affects your credit.

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.

Like many personal finance questions, the impact of debt consolidation on credit scores depends on you. It’s personal. There are a few general results you can expect, though. We’ll focus mainly on debt consolidation loans, then look at a couple of alternatives for consolidation.

How debt consolidation can harm your credit

It’s true that debt consolidation can hurt your credit, but you have some control over this.

Here are some key reasons your score might decrease due to debt consolidation:

• Hard credit check during loan application
• Impact on length of credit history or age of accounts
• Potential for increased debt in some cases

Generally, your credit score will take a hit initially. This is because if you take out a debt consolidation loan, the lender will perform a hard credit check. Applying with multiple lenders could increase this drop in your credit score.

FICO considers credit inquiries from the past 12 months when calculating your score. Applying for new credit cards or personal loans (as the type you’d use for debt consolidation) typically drops your score by a few points. New credit also accounts for 10% of your FICO score.

A debt consolidation loan also affects the age of your credit or the length of credit history. This newer loan can decrease your average age of accounts, which may drop your score. It likely won’t impact your score as much if you have a large number of accounts on your credit history, though.

This third reason is one to consider if you tend to spend more than you have. If you can imagine using debt consolidation to pay off debt and then using that as an excuse to spend on credit cards again, debt consolidation might hurt your credit even further.

You have to know yourself in this instance. To be honest, I wouldn’t worry too much about that potential future debt, because the benefits of getting out of debt are probably worth the risk. Bottom line: you need to get debt-free.

How debt consolidation can help your credit

Here’s the thing: while debt consolidation can initially make your score dip, in the long-term, your credit score may actually go up.

Here’s why:

• Possibly improved payment history
• Potentially lowered credit utilization
• Increased likelihood of paying off debt in full

When you consolidate debt, you might end up with lower interest rates and lower monthly payments. This helps facilitate your making payments on-time, which improves your payment history over time and improves credit.

You might also lower your total credit utilization with debt consolidation. Credit utilization looks at how much of your available credit you’re using at a time. If you shift a lot of revolving credit such as credit card debt to a personal loan, FICO views it differently and this may give you a better credit utilization ratio. Plus, you have a greater amount of available credit due to the new loan, which lowers your ratio.

Finally, you should ideally pursue debt consolidation if it’ll make it easier to pay off all of your debt in a timely manner. If you do this properly, you’ll eventually owe a lot less (or nothing at all), which is excellent for your long-term credit scores.

Quick example of credit utilization:

Let's say you have three credit cards:

• Credit card 1: $5,000 limit; $3,500 balance
• Credit card 2: $3,000 limit; $2,000 balance
• Credit card 3: $1,500 limit; $1,500 balance

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 30 percent or less — can help raise your score.

Taking out a debt consolidation loan 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.

Who should use debt consolidation to help their 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. Maybe you’ll be able to build an emergency fund that can help you avoid taking on more debt when unexpected bills crop up.

If these factors apply, you might be a good candidate for debt consolidation:

• You have decent enough credit to qualify for a better interest rate
• You’re struggling to make minimum payments and keep track of multiple debts
• The potential savings outweigh any loan origination fees

Other methods for debt consolidation

Aside from a personal loan intended for debt consolidation, you have a few other options to consider that also combine your loans and create a new single payment:

• Balance transfer
• Home equity loan or HELOC
• 401(k) loan

Balance transfer

You might apply for a 0% interest promotional offer on a new credit card. Transfer your debt from high-interest cards to the new card, then aim to pay it off before the introductory period ends.

Using a balance transfer card can be effective as long as you read the fine print. Be sure to understand how much the fees are for balance transfers (sometimes cards charge you a percentage of the transferred amount) and how many months until your interest rate will go up.

Unfortunately, you might not qualify for ideal rates if you don’t have a good credit score to begin with, so this depends on whether you’re getting balance transfer offers.

Other potential downsides with balance transfers include:

• Interest skyrocketing after the intro period (if you don’t pay it all off)
• Balance transfer fees
• Risk of overspending on the new card

Home equity loan or HELOC

If you’re a homeowner, you may be able to get a home equity loan or home equity line of credit (HELOC) to help you consolidate and repay debt. This may come with a lower interest rate than a personal loan and could even have longer repayment terms, but there are cons to consider as well.

One major issue to think about is that you'd be putting your home on the line with a home equity loan or HELOC. I’d think carefully before using my home as collateral on other debts, for sure. Figure out whether that’s a risk you can afford to take.

Is debt settlement a good alternative to debt consolidation?

You may be wondering about debt settlement vs. debt consolidation. Debt settlement can sound appealing — the chance to pay less than what you owe. But debt settlement is much riskier and will harm your credit more. Some debt settlement companies are less than reputable as well, and you typically have to stop payments when using this tactic (which is terrible for your credit).

In debt settlement, 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.

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’re trying to avoid bankruptcy, debt settlement could be a viable option.

FAQs

Is debt consolidation 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. I love this strategy because 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 are 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.