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.
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What You Need to Know About 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).
Debt Consolidation Will Affect Your Credit Score
Debt consolidation could knock your credit score down by anywhere from a few points to an entire level, but allowing loans to default will damage your credit score even more. How severe the damage will be depends on the credit score you start with. Ironically, the higher your score, the more significant the initial hit will likely be. The good news is that damage is only temporary! Over time as you work to pay down your consolidated debt, your score will recover and probably get even better than before you decided to consolidate.
Here’s the rundown 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, your credit utilization ratio will be lower. The lower the ratio, the higher the score!
How Debt Consolidation Hurts Your Credit
As mentioned earlier, your credit score will take a hit in the early stages of debt consolidation. 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 various 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 on your report, the more desperate you seem, making 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 show you 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 a loan, 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
Working with a professional debt consolidation company 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 will 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?
READ MORE: Best low-interest debt consolidation loans
Benefits and Drawbacks
Outside of the impact on your credit score, other pros and cons are associated with consolidating your debt.
On the pros side, having just one payment each month on the new loan is much easier than making 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 cons side, particularly in the short term, debt consolidation can negatively affect your credit score. If you’re diligent, you can help that score rebound and rise. Can you afford to take that hit right now, though? Something to consider.
READ MORE: Debt consolidation vs. debt settlement
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 monthly payments because you have too many to make? Consolidation could be the answer. Are you ready to attack your debt so 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 your accounts, you might be better off simply contacting each creditor and re-negotiating your rate.
Other Ways to Get Debt Relief
There are, of course, other ways to consolidate debt. For example, homeowners have the option of a home equity loan, or a 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.
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!
Secured debt is backed by collateral, such as a house or car. If a borrower defaults on the loan, the lender can seize the collateral and sell it to recover their losses.
Unsecured debt is not backed by collateral. This means that the lender has no asset to seize if the borrower defaults on the loan. Examples of unsecured debt include credit card debt, medical bills, and personal loans.
Debt consolidation can both help and hurt your credit score. There are many factors involved, including:
The credit inquiry: When you apply for any new loan, the lender will probably check your credit report. This is known as a hard inquiry. Hard inquries temporarily lower your credit score by a few points.
Payment history: Payment history is a key factor in determining your credit score. If you make on-time payments on your consolidated debt, it will increase your credit score.
Credit utilization: This is the amount of credit you’re using compared to the total you have available. The new loan to consolidate your debts may help lower your credit utilization ratio. This can help boost your credit score.
Length of credit history: If you’re consolidating multiple accounts, this may shorten your credit history. This could lower your credit score. However, it usually bounces back quickly.
In the short term, debt consolidation will have a mixed impact on your credit score. However, the potential long-term benefits of debt consolidation will outweigh the short-term negative impact and eventually will lead to a better score.
Costs of a balance transfer credit card are relatively low if the card has a 0% APR introductory offer. However, most cards charge a balance transfer fee ranging from 3% to 5% of the total debt transferred. That low interest rate will only be in effect for a limited time, so costs will increase if you can’t pay off your debt by the time the introductory offer ends.
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 it is mistake-free to ensure 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 your score will continue growing!