Is debt consolidation a good way to get out of debt?

Debt consolidation does increase your credit score if you handle the loan or credit card account properly. The lender or issuer will likely report positive information to the credit bureaus every month, as long as you make the payments on time, which will increase your credit score over the life of the loan.… read full answer

For example, around 68% of consumers who consolidated saw their credit score increase by more than 20 points, according to a TransUnion study. Of all the consumers in the study, those with subprime credit scores before consolidating saw the most improvement.

To estimate how much debt consolidation may impact your credit score, check out WalletHub’s free credit score simulator.

Just keep in mind that even though you will see long-term credit score improvement when you consolidate debt, it can also hurt your credit score in the short term. The hard inquiry into your credit history when you apply for a loan or credit card will likely drop your score by about 5 - 10 points. Additionally, any payments that are 30+ days late will damage your score.

The cons of debt consolidation are that it's hard to get a worthwhile rate with below-average credit, not all debts are eligible, and there is a possibility of fees. There is also the danger of debt settlement services posing as debt consolidation, which can lead to significant credit-score damage.

The pros… read full answer of debt consolidation outweigh the cons, but it's important to consider both sides when you're thinking about consolidating.

5 Drawbacks of Debt Consolidation

• Hard to qualify with bad credit

  If you have bad credit, you can still get a loan or credit card to consolidate your debt, but it likely won't have a better interest rate than your existing debts.

  Personal loans without origination fees also require a fair credit score (usually 660+). For a home equity loan, a home equity line of credit or a good balance transfer credit card, you'll need a score of 700 or higher.

• Not all debts are eligible

  Not all consolidation options support all types of debt. For example, credit card issuers often limit the types of debt that you can move to a credit card through a balance transfer.

• Hard inquiries

  Applying for a new loan or a balance transfer credit card triggers a hard inquiry. This will temporarily decrease your credit score. After a few months of on-time payments, it'll get back to where it was.

• Possibility of fees

  You may need to pay fees in order to consolidate debt. Some personal loans have origination fees of 1% - 8% of the loan amount, and some credit cards have balance transfer fees of 3% - 5% of the transferred amount. Keep an eye out for these fees when comparing your options.

• Settlement posing as consolidation

  Debt settlement programs often advertise themselves as debt consolidation programs. With debt settlement programs, you'll still make monthly payments to the company that's "helping" you, but it will withhold the money from your creditors until they reach a settlement to pay only a portion of what you owe and have the rest forgiven.

  Even though this seems like a good thing, it causes a lot of credit score damage by forcing you to miss payments and potentially default on what you owe. The company will charge you fees of 15% to 20% of the original debt, too.

Debt consolidation can affect your credit score negatively in the short-term if you get a loan or credit card and the lender performs a hard inquiry into your credit history. In the long-term, debt consolidation can affect your credit score positively if you make your monthly payments on time.

To estimate how debt consolidation may affect your credit score in particular, check out the … read full answerfree credit score simulator on WalletHub. You can also read more about debt consolidation’s impact below.

How Debt Consolidation Affects Your Credit

Hard inquiry

If you get a debt consolidation loan or a balance transfer credit card, the lender will more often than not do a hard inquiry into your credit history. A single hard inquiry will likely drop your score by about 5 - 10 points, and many inquiries into your credit history within a short period of time can cause more significant damage.

New account on your credit reports

New credit represents about 10% of your credit score. The addition of a new credit card or loan account may temporarily damage your score. On the other hand, the longer your accounts are open and in good standing, the better your credit score should be.

Changes to your credit utilization

Credit utilization – the ratio of how much credit you’re using compared to your credit card limits – is included in a segment that accounts for 30% of your overall score. If you consolidate your debt with a balance transfer credit card, your overall credit utilization could increase, damaging your score. On the other hand, consolidating your debt with a loan could lead to a drop in your overall credit utilization, which would cause your score to increase.

Payment history

When you make a monthly payment on time, the lender will report positive information to the credit bureaus, which will increase your score. However, if you don’t make payments, the lender will report negative information and your score will go down.

There’s no way to know exactly how debt consolidation will affect your credit score. But in most cases, debt consolidation will lead to long-term credit score improvement since it decreases your odds of default and puts you on more stable financial ground. To estimate how consolidation will impact your score, check out WalletHub's free credit score simulator.