Debt consolidation does not hurt your credit score much in the short term and will actually help improve it over time. Debt consolidation is one of the primary options available to indebted consumers who are looking to ease their path to zero balances as well as save money and protect their credit standing in the process. Unlike other alternatives – such as debt management, debt settlement and even bankruptcy – debt consolidation, when done right, won’t damage your credit standing in any significant manner.
You can check out our Debt Consolidation Overview if you don’t know exactly how it works, but the basic theory behind debt consolidation is that you can use a new loan or line of credit to pay off existing debt obligations in order to garner a lower overall interest rate and a more manageable monthly payment.
Theoretically, this can enable you to pay down what you owe faster and avoid missing payments. However, the value of debt consolidation – both in terms of your credit standing and the bottom line – depends on the nature of your particular financial situation as well as what type of debt consolidation you pursue.
How Does Debt Consolidation Affect Your Credit?
While the credit implications of debt consolidation may seem minimal, debt consolidation does have the potential to affect the way in which financial institutions and other decision makers view your creditworthiness. For example, reduced interest rates through debt consolidation can enable you to stay on top of your monthly debt payments. This positive repayment history will increase your creditworthiness, as it proves to creditors that you can meet your financial obligations.
The short-term impact of debt consolidation can be positive or negative, but is likely to be minimal either way.
How debt consolidation could hurt your credit in the short-term:
- A Hard Inquiry: The financial institution that approves your line of credit will need to review your credit history before making a decision about your application, and when they “pull” your credit reports, a “hard inquiry” will be noted on your files. A single hard inquiry isn’t likely to affect your credit much, but numerous inquiries into your credit history within a short period of time can cause your credit score to take a dip for about six months.
- A New Account on Your Credit Reports: Each time you open a new loan or credit card account, the new trade line will be noted on your credit reports. This too will result in temporary credit score damage. New Credit – which includes inquiries as well as new trade lines – accounts for about 10% of your credit score.Most types of debt consolidation require opening a new account to pay off your original debt obligations. The notable exceptions are if you take a loan against a retirement account or the equity in your home.
- Changes to Your Credit Utilization: Credit Utilization – the ratio of your credit card balances and spending limits – is a component of the Amounts Owed section of your credit score, which accounts for roughly 30% of your overall score. If you keep your original accounts open after consolidation, your utilization for each of these accounts will move to 0%, and your aggregate utilization will decrease (boosting your credit).If you close the original accounts, credit utilization will no longer be calculated for them and your aggregate utilization will either remain the same or increase because you no longer have those credit lines boosting your overall available credit.
The end result for your credit score after debt consolidation is impossible to determine ahead of time as it depends on multiple factors, including the extent of your credit history, your open accounts, and the actions you take after consolidation. In most cases, however, debt consolidation will lead to long-term credit score gains, since it will decrease your odds of default and put you on more stable financial ground.
What Happens to Your Credit After Debt Consolidation?
What you do after you’ve consolidated your debts into a single loan or line of credit can have a greater impact on your credit standing than the act of consolidation itself. After all, debt consolidation merely makes your debt easier to deal with; it doesn’t reduce what you owe or address the underlying issues that caused you to get into debt in the first place.
As such, if you wish to use debt consolidation as a bridge to debt freedom and credit improvement, you must make sure to:
Adhere to a Strict Payment Schedule: It’s essential that you carefully evaluate the affordability of a debt consolidation loan or line of credit before opening it and that you make the necessary monthly payments thereafter. Otherwise, you’ll just wind up missing payments, wasting money on interest, and incurring credit score damage all over again. The only difference will be that you’ll have wasted a lot of time and debt consolidation may no longer be an option for solving your problems.
The best approach is to use a calculator to determine how much you can afford to allocate toward debt payments each month. This will give you a sense of what type of debt consolidation is feasible as well as whether or not you’ll have to adjust how much you spend on other things.
Make a Budget: A budget is necessary to prevent history from repeating itself in an overleveraging sense. This might seem like basic advice, but only 2 in 5 consumers maintain a budget, according to surveys from the National Foundation for Credit Counseling. One simple way to devise an effective budget is to make a list of your expenses from the last few months, calculate how much you’ve spent per month, and eliminate those expenses that you can’t afford and that are unnecessary. In doing so, don’t forget to include your monthly debt payments.
Monitor Your Spending & Payment Habits: A budget only works if you stick to it. You therefore need to regularly monitor your monthly expenses as well as your ability to pay for them and adjust accordingly. The Island Approach can be a helpful ally in this pursuit. More specifically, now that you have all of your debt consolidated into a single account, you should open a credit card account to use purely for everyday expenses. You should always be able to pay for such purchases in full, so if finance charges show up on this account at the end of a given billing period, you’ll know that you’re overspending.
Debt consolidation can be a helpful way to organize your debt obligations as well as garner a lower interest rate and a more manageable monthly payment in the process. The act of consolidating your balances can affect your credit in the short-term given that it likely requires opening a new loan or credit card. However, the manner in which you manage your consolidation account and conduct your finances thereafter will have a far greater bearing on your credit standing when all is said and done.
If you manage your financial obligations responsibly after debt consolidation, it will turn out to be one of the best decisions you could have made for your wallet. You can check your latest credit score for free on WalletHub and track your progress daily. You’ll also get personalized credit-improvement advice.