Does Debt Consolidation Hurt Your Credit? What You Need To Know
If you’ve racked up a lot of high-interest debt, you may be looking for a way to get a handle on it. Debt consolidation allows you to roll several monthly payments, typically from credit cards, into one monthly payment at a lower interest rate. However, this may bring to mind a question: Does debt consolidation hurt your credit?
How Debt Consolidation Affects Your Credit
Although there are several options, one of the most popular methods of debt consolidation is applying for a personal loan. Among the big advantages to this strategy is that funding is quick and the loan is unsecured, meaning you don’t have to worry about putting up collateral.
Any time you apply for a loan, you should understand the impact it has on your credit score. Taking on new debt – even to consolidate existing debt – shows up on your credit report. While FICO® makes it clear that some of the weights may be different on the typical components of a credit score, here is a general overview of each one.
- Payment history: Lenders want to know that you’re consistently making at least the minimum payments on time consistently. This makes up 35% of your credit score.
- Unpaid debt: The next 30% of your score looks at the remaining amount you owe on debt you’re currently paying off. This includes installment debt, but there are also subcomponents for revolving debt. It’s generally not recommended that you use more than 30% of your available revolving credit balance.
- How long you’ve had your loans or credit accounts: Lenders also look at how long you’ve had credit or outstanding loans. The longer your history, the better the read they’ll get on how you handle debts. This accounts for 15% of your score.
- Number and type of loans or accounts you have open: Often referred to as credit mix, this looks at how many accounts you have and how many are installment vs. revolving debt. Lenders like to see a mix of both. This makes up 10% of your score.
- New applications for credit: When you apply for a new loan or credit card, a hard credit inquiry is made. The application is a small signal to lenders that you’re looking to get access to funds for some purpose and that you may be overextending yourself. New credit applications account for 10% of your score.
Any method used to consolidate debt impacts almost all of these factors with the exception of your past payment history (though it will shorten the average age of your credit accounts).
How Debt Consolidation Can Hurt Your Credit
If you’re considering debt consolidation, you should know that it can impact your score negatively in the following temporary ways:
- Hard credit inquiries: When you accept a new loan, it can be an indicator that you’re spreading yourself thin financially. This will typically lower your score by 5 points or less and your score will bounce back within a couple of months as long as you make on-time payments. Soft credit inquiries to check your options or view your credit report don’t impact your credit score at all.
- Closing credit accounts: Closing an account can negatively impact your score in a couple of ways. For starters, if you close an account, you have to be sure to pay down the balance rather than transfer it or you could be increasing your credit utilization ratio. As an example, say you have two credit card accounts, both with $5,000 limits. If you have a $1,000 balance on Card A and a $1,500 balance on Card B, closing Card A to move the balance over to Card B to take advantage of a temporary interest-free deal on balance transfers increases your credit utilization because you’re decreasing your available balance ($2,500 ÷ $10,000 ×100 = 25% vs. $2,500 ÷ $5,000 ×100 = 50%). It’s important to keep a special eye on this because credit utilization rolls up to amounts owed, which is 30% of your credit score. Closing accounts can also lower the average age of the accounts you have open, which makes up 15% of your score. This is more likely to bounce back quicker if you make payments on time, but you should be aware.
How Debt Consolidation Can Help Your Credit
There are short-term, negative impacts associated with debt consolidation options, but there are also long-term gains to be had.
- Payment history: If you’re able to consolidate your debt into something with a more affordable monthly payment with a lower interest rate, that can help your ability to make payments on time. This alone will have a major impact on your score because it’s the biggest weight in the FICO®
- Credit utilization: We talked about how debt consolidation can hurt credit utilization, but it all depends on how the math is working out. If you’re going from a smaller credit limit to a bigger one, taking advantage of a balance transfer deal while closing an account you no longer want to use could actually make sense. For example, let’s say you’re opening a brand-new account and are approved for a $7,500 limit. You have a $1,500 balance and a $5,000 limit on the card you want to close. In this case, your credit utilization decreases from 30% ($1,500 ÷ $5,000 ×100 = 30%) to 20% ($1,500 ÷ $7,500 ×100 = 20%).
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Is Debt Consolidation Bad For Your Credit?
While a hard credit inquiry will negatively impact your score, the effects are temporary. If you make your payments on time and get rid of your debt, debt consolidation can be good for your holistic financial health long term, including credit.
Forgetting credit and focusing strictly on finances for a minute, anything that makes your payments more affordable is better for your bottom line. The actual impact on your credit is going to depend on how you go about your debt consolidation.
Is Debt Consolidation Worth Hurting Your Credit Score?
In any of the options offered for debt consolidation, there could be a short-term negative impact from things like a temporary impact on credit utilization or the closure of an older account. However, long-term there could be positive impacts on your payment history and you may owe lower amounts over time as you continue to pay off debt.
Debt consolidation makes the most sense if you can save on interest. You could also be consolidating into a payment or two as opposed to trying to keep track of several different payments that could all be due on different dates. Finally, the lower interest could mean the ability to pay off your debts faster.
Consolidate debt with a cash-out refinance.
Your home equity could help you save money.
Alternative Methods For Debt Consolidation
We’ve briefly discussed the option to get a personal loan. It’s worth noting that because personal loans aren’t backed by anything physical, you may need a higher credit score to qualify. Additionally, the interest rate may be higher than some of the alternatives we’ll discuss next (though still lower than a credit card). Here are several alternatives:
- Cash-out refinance: In a cash-out refinance, you replace your existing mortgage with a brand-new one at a different rate and term. Because the loan is backed by your home, you can roll the debt into your loan amount while still receiving a rate that could be a third or less of what the credit card rate might be. You’ll need significant equity (often the minimum equity amount after closing is 20%) to do this. Additionally, you’ll need a qualifying credit score of 620 or better.
- Home equity loan: A home equity loan could be a great alternative in a couple of ways. It’s a second mortgage on your home, so the rate will be higher than a cash-out refinance, but depending on how much you’re looking to borrow, a blended rate calculation might show you that the net interest rate between your two mortgages would be lower than if you were to refinance your primary mortgage. It’s worth doing the math in a rising-rate environment. The other big potential advantage is that you can borrow up to 90% of your home value, which may give you breathing room to accomplish your debt consolidation goals with your existing amount of equity.
- HELOC: A HELOC is a second mortgage like a home equity loan, except that it functions more like a credit card (albeit with a lower rate). For the first 5 or 10 years you have your credit line, you can use the amount you’re approved for toward debt consolidation, home improvement or anything else. During the draw period, you only make payments on the interest. Following the initial draw period, the balance freezes and you can no longer access it. Once this occurs, you make payments on principal and interest for the rest of the term.
- Balance transfer credit card: This is something to be careful about because you don’t want to get in a habit where you’re transferring balances from card to card to try and outrun your debt. However, some people may find success if they can get a deal involving several months with no interest charged on a balance transfer. They then pay off the transferred funds during the no interest period.
- Debt management plan: Sometimes you can find a credit counseling agency that will work with you on a debt management plan, essentially taking a look at your budget and coming up with a plan to pay your creditors some amount over the next 3 – 5 years. If you do this, you typically have to close all existing accounts. Second, your creditors have to agree to this and they may not all do so, so you could still wind up with multiple monthly payments. Additionally, the agreement will likely be listed on your credit report as “paid as agreed” if it’s anything less than the full balance. However, this is still better for your credit than if you had paid nothing at all.
FAQs About How A Debt Consolidation Loan Affects Your Credit
Now that you have an understanding of the basics, let’s get into some of the frequently asked questions that come up around debt consolidation.
Does consolidating debt affect my credit score?
Debt consolidation affects your credit score initially in a negative way, but it’s meant to be a positive in the long-term. The short-term hit to your score should be outweighed by the ability to consolidate several high-interest accounts into one while you pay a significantly lower interest rate. This also often allows people to pay down their debt faster.
What are the negative effects of debt consolidation?
The negative effects depend on how exactly you do your debt consolidation. If you plan on taking out a new loan or line of credit to consolidate your debts, it will result in a hard inquiry and a potential change in your credit utilization. Additionally, there is a penalty for closing long-standing accounts because it lowers your average age of credit.
Finally, if you choose to move forward with a debt management plan, know that having something “paid as agreed” doesn’t look as good on your credit as paying the balance in full does.
How long does debt consolidation stay on your record?
If you go the route of a new loan or line of credit to consolidate your debt, it stays on your credit report for as long as the account is open. It can also remain for several years afterward, but loans you paid off are a positive signal anyway. Closed accounts that are “paid as agreed” under a debt management plan show up for up to 10 years.
The Bottom Line: Debt Consolidation Is About The Big Picture
Although debt consolidation can have negative impacts in the short term due to new hard inquiries, changes in credit utilization and a drop in the age of your credit, it’s worth noting that the long-term positive impacts can far outweigh the negatives. For example, you could get down to one payment that has a lower interest rate. This might allow you to pay off debt faster.
If you have enough equity in your home, a cash-out refinance or home equity loan may be the way to go. You can apply online.
