Debt consolidation can potentially hurt your credit score if you don’t use the new loan responsibly, such as by missing payments or taking on even more debt instead of only paying off old debt. However, if you use it correctly, debt consolidation can have a positive impact on your credit score and help you pay down debts faster.
Key Takeaways
- Making on-time payments on all your outstanding debt can cause your score to increase.
- Making late payments and missing payments will each result in your credit score decreasing.
- Consolidating debt can have both good and bad impacts on your credit score and history. Responsibly repaying your debt consolidation loan or line of credit can have a positive impact on your credit score.
Understanding Debt Consolidation
Debt consolidation is when you combine multiple debts into one, so you can streamline your debt payments, typically with lower interest rates. You may use debt consolidation for a number of reasons, such as to reduce the total amount of interest you're paying, to lower your monthly payments, or to combine multiple bills into one.
Debt consolidation can include different types of financial products, including balance transfer credit cards, personal loans, home equity loans, or even loans from your 401(k). You can use either of these to pay off your outstanding debt and then make one manageable payment on your new loan.
To consolidate debt, you first apply for a loan, such as a personal loan or credit card. You then use the new loan to pay off your debts or transfer your current debt to your credit card. You continue to make the minimum payments on your old loan or credit card until your debt it is officially consolidated. After that, you only pay your new lender. If your new loan has a lower interest rate, you can pay off your debts faster.
How Debt Consolidation Affects Your Credit Score
By getting a debt consolidation loan to pay off your debt faster, you can focus on other financial goals. However, if you don’t use debt consolidation responsibly, your credit score may not improve. For example, if you have many late payments or missed payments on your new debt consolidation loan or line of credit, your credit score will worsen.
However, debt consolidation can have many advantages. Consolidating debt and streamlining payments can help you pay off old debt sooner and save you money in interest in the long term.
If you were behind on payments, paying off that debt makes you current. Continuing to make on-time payments on your new loan or line of credit will also help improve your credit score.
Pros
Increased available credit
Improved payment history
Expanded credit mix
Cons
New credit inquiry
Increased credit utilization
Shorter credit history
Pros Explained
- Increased available credit: When you pay down your credit cards with a new line of credit or loan, you increase your available credit and decrease your total credit utilization, both of which boost your score. As long as you don’t use your new available credit, the impact of increased available credit from debt consolidation will have a positive effect on your credit.
- Improved payment history: Your payment history determines 35% of your FICO score, making it the biggest factor in calculating your credit score. The more on-time payments you make on all your debt, the more your score increases. Adding a loan or line of credit gives you the chance to increase your positive payment history.
- Expanded credit mix: Another part of your credit is your credit mix, which makes up about 10% of your FICO score. This is how many different types of credit you have, such as installment loans like personal loans or revolving lines of credit like credit cards. Adding a new loan for consolidation may improve your credit mix.
Cons Explained
- New credit inquiry: Any time you apply for new credit, whether it’s a loan or credit card, your credit report gets dinged. This causes your score to decrease temporarily, but your credit typically rebounds after a few months of on-time payments.
- Increased credit utilization: If you pay off a loan or credit card and close it, your available credit decreases, which increases your credit utilization. Even if you aren’t using more credit, increasing your credit utilization by closing available credit can cause your score to fall.
- Shorter credit history: Adding new credit to your report means your average credit history will go down. Your FICO score takes into account the age of your oldest account, your newest account, and the average age of all accounts. A longer credit history will boost your credit score, while a shorter credit history can have a negative effect.
One alternative to debt consolidation may include debt settlement, in which you negotiate with your lender to pay a lower amount. This strategy will reduce your debt, but this can also have a negative impact on your credit score.
Tips for Minimizing Negative Impact on Credit
While some negative impacts on your credit score are inevitable when you use a debt consolidation loan, you can minimize this harm in a few different ways. Here are some steps you can take.
1. Check Your Credit Before Applying
Before completing any loan applications, check your credit score and history. This gives you an idea of what lenders will see when they run a credit check. It also helps you understand what loans or lines of credit you’re likely to get approved for. You can check your credit report for free on AnnualCreditReport.com.
An excellent credit score makes you more likely to get approved for a loan or credit card at the lowest interest rate. Having good, fair, or even bad credit doesn’t mean you won’t get approved—but you might have a harder time getting the interest rate and terms you'd prefer.
Additionally, be sure to look for credit cards or loans that offer pre-qualification. This is a soft credit check and doesn’t hurt your credit score. Pre-qualification doesn’t guarantee you’ll get approved, but it does give you an idea of which lenders are willing to give you a loan or credit card.
Instead of completing applications with many different lenders, consider only submitting applications with just those that have pre-qualified you.
2. Compare Loan Terms
Debt consolidation can help you minimize the interest you pay on your debt. However, if your goal is to reduce the cost of interest, it’s important to compare available offers to make sure you’re getting an interest rate that’s not worse than your current one.
If the rates you're offered aren’t as low as or lower than what you're currently paying on your debt, consolidating may not be the best move. In some cases, you could end up paying more than what you’re already paying. Debt consolidation will only hurt your credit if you can’t afford your new payments and fall behind or miss them completely.
3. Pay on Time
Taking out a new loan or credit card means you’re adding a new financial responsibility to your budget. It’s great that you’re using those funds to pay off other debt, but don’t forget about this new bill. Payment history is crucial to your credit score, so late or missed payments will hurt your credit for a while.
Consider setting up autopay for at least the minimum amount due by your due date. This way you’ll never miss a payment and it’s easier to stay current. If you ever get any extra funds, like a bonus from work or money from a side hustle, you can make an extra payment on your credit card or loan. Most lenders don’t charge prepayment penalties, but check the terms of your loan just to be safe.
What Is the Best Way to Consolidate Debt?
You can consolidate debt in a number of ways, and the best way will depend on your personal financial situation and loan options. Generally, you want a consolidation to lower your interest or amount of monthly payments. For example, with a balance transfer credit card, you may get an introductory 0% annual percentage rate (APR) for a set term, which can help lower your total interest costs. You can also take out a personal loan to pay off your outstanding debt. You’ll then make one monthly payment on your new loan.
Does a Debt Consolidation Loan Close Your Credit Cards?
A debt consolidation loan doesn’t automatically close your credit cards. If you’d like to cancel your cards, you’ll need to contact your credit card issuer directly.
How Long Does it Take for Credit Scores to Recover After Debt Consolidation?
Your credit score may be hurt temporarily after any hard credit inquiries, but being responsible with your credit by making all minimum payments on time will help you improve your credit within a few months.
The Bottom Line
Debt consolidation can have several advantages, including saving you money by reducing the total amount of interest you pay to lenders. It can also help you simplify your finances by consolidating multiple monthly payments into one. Consider consulting with a professional advisor to determine whether a loan consolidation may be right for you, and which strategy would best suit your needs.
