Does Debt Consolidation Hurt Your Credit?
Debt consolidation is one of the primary options available to indebted consumers who are looking to ease their path to zero balance 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. In fact, it will be beneficial in the long run.
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.
Debt Consolidation & Your Credit Standing
You may assume the credit standing implications of debt consolidation to be minimal since the process basically entails rearranging debt into a single balance, rather than paying it off, but it does have the potential to affect the way in which financial institutions and other decision makers view your credit worthiness.
The short-term impact can be either positive or negative, but either way the change will be minimal. The end result is impossible to gauge ahead of time – as it depends on multiple factors, including the extent of your credit history, the accounts you have open, 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.
With that said, debt consolidation can affect your credit in the short-term in the following ways:
- A Hard Inquiry: By now, you’re aware that debt consolidation necessitates applying for a new loan or line of credit in order to pay off your various debt obligations and shift your total liability to a single financial institution. Well, that financial institution will obviously 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, but numerous inquiries into your credit history within a short period of time can cause your credit score to take a slight 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, essentially warning anyone who looks into your credit history in the near future that you have yet to completely prove your ability to handle recently-acquired credit. 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 exception is if you take a loan against a retirement account.
- Changes to Your Credit Utilization: Credit Utilization – the ratio of your debts to available credit – is a component of the Amounts Owed section of your credit score, which accounts for roughly 30% of your overall score. The way in which debt consolidation affects your Credit Utilization depends on whether or not you close your original accounts upon paying off your existing balances with a new loan or line of credit. If you keep them open, your utilization for each of these accounts will move to 0%, and your aggregate utilization will decrease. In other words, it will benefit your credit standing. 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 Aftermath of Debt Consolidation & Your Credit
What you do after you’ve consolidated your debts into a single loan or line of credit will have perhaps 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, tabulate how much you’ve spent per month, and eliminate those expenses that you can’t afford to pay for. 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 having finance charges show up on this account at the end of a given billing period will indicate 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 account – which impacts the New Credit portion of your credit score – and will alter your credit utilization ratios – part of the Amounts Owed section of your credit score.
However, the manner in which you manage your consolidation account and conduct your finances thereafter will have far greater bearing on your credit standing when all is said and done. If you manage your financial obligations responsibly in the aftermath of debt consolidation, it will turn out to be one of the best decisions you could have made for your wallet.
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