Does Debt Consolidation Affect Your Credit Score?

A common approach to paying off multiple debts, debt consolidation can help a borrower to streamline their personal finances. This method of simplifying debt repayment comes with a number of pros and cons, leading some to wonder, “What does debt consolidation do to your credit score?”

The answer ultimately depends on an individual’s credit history. Since understanding how debt consolidation works is a crucial part of financial literacy, let’s discuss some of the pros and cons.

What is debt consolidation and how does it work?

Debt consolidation is the process of taking out a single loan to pay off two or more debts, such as auto loans, mortgages, and credit card debts. For some, this can be an effective way to reduce their number of monthly payments and prevent interest from compounding on multiple outstanding balances.

However, there are some potential risks of debt consolidation, as well. For instance, missing a payment on your debt consolidation loan could have larger consequences, and there may be high up-front costs associated with opening your account.

Loans designed for debt consolidation can be either secured or unsecured. A secured loan is backed by collateral, such as a vehicle or personal property, which lenders can seize in case of a default.

In contrast, an unsecured loan is not backed by anything, which makes it more difficult to qualify for and often comes with a relatively higher interest rate. Aside from taking out a dedicated debt consolidation loan, a borrower can apply for a personal loan, home equity loan, or balance transfer credit card.

Balance transfer credit cards are a common way of consolidating debt. With this method, you transfer the balances of your high-interest credit card debts to a new credit card with a lower interest rate.

Keep in mind these credit cards usually come with a balance transfer fee and a limited introductory period for their low interest rates. In addition, borrowers with bad credit may not be able to receive approval for this type of credit card.

Regardless of the approach to debt consolidation, the end goal is to consolidate debt into one monthly payment at an interest rate lower than those on the individual debts.

How can you apply for a debt consolidation loan?

Start by calculating your total debt load and determine how much you can afford to pay each month. When consolidating debt payments, do your due diligence by comparing interest rates, fees, and repayment terms offered by different loan issuers.

After taking these steps, you can apply for a debt consolidation loan. Upon receiving your application, a loan issuer will send a credit inquiry request to the major credit bureaus, which include TransUnion, Equifax, and Experian.

This allows the lender to review your credit report, which lists financial information such as your revolving credit and the types of loans you currently have open, also referred to as your credit mix.

If the issuer approves your loan application, you can use the funds to pay off your outstanding debts. Then you’ll have to make monthly payments on your consolidation loan.

In many cases, you may end up with a lower interest rate on your consolidation loan than what you would have paid on your other debts, potentially saving money over time.

Keep in mind that consolidating your debt will not automatically fix your financial problems — you’ll still need to make regular monthly payments on your consolidated loan.

Late payments on your consolidation loan could result in a derogatory mark on your credit history. Plus, loans can accrue interest just like credit cards, so it’s generally important to be aware of your interest and do what you can to pay off your debt as quickly as possible.

And if you’re consolidating debt with a home equity line of credit (HELOC), it is generally recommended to use the funds in a strategic way and make on-time payments. Homeowners who miss payments on a HELOC could put their property at risk of foreclosure.

What is the average debt consolidation interest rate?

Personal loan interest rates fall around 10.16% on average.

However, the interest rate on your debt consolidation loan will largely depend on your credit score and financial history. With excellent credit, you may be able to qualify for a consolidation loan with a lower interest rate.

When considering a debt consolidation loan, take into account whether a short or long-term loan makes more sense for your financial situation.

A short-term loan may have higher monthly payments but save you money on interest over the duration of the loan. On the other hand, a long-term loan might have lower monthly payments but cost you more in interest.

How long does it take to consolidate debt?

The length of time it takes to consolidate your debt depends on a number of factors, including how much debt you have, your types of debt, and what method you use to consolidate your debt.

Loan issuers each have their own unique process when it comes to reviewing and approving applications, which can take anywhere from days to months. For instance, lenders may approve a borrower for a balance transfer credit card in only a day.

On the other hand, while it can take less than an hour to fill out a student loan consolidation application, a borrower may have to wait between one and three months before receiving an approval.

How can debt consolidation affect your credit score?

When you consolidate debt, you’re essentially taking out a new loan and using it to pay off existing debts. This new loan will show up on your credit report, which can impact your credit score in a few different ways.

First, if you consolidate debt with a new personal loan or balance transfer card, you may see a short-term dip in your credit score. This is because lenders have to run a credit check to assess your creditworthiness, which results in a hard inquiry on your credit report.

In addition, the new account could affect the average age of all your existing loans and credit card accounts. The three main credit bureaus all use the length of your credit history to calculate your credit score.

However, if you make all of your loan payments on time and in full, this temporary dip should reverse itself within a few months. Plus, consolidating your debt can help you improve your credit utilization ratio, or the amount of debt you have compared to the amount of credit available to you.

A lower credit utilization ratio is better for your score, so consolidating your debt into one lower-interest loan might improve your score over time. Lastly, keeping up with consolidated loan payments can improve your payment history, which is one of the biggest factors in many credit score calculations.

So even though consolidating debt may cause a small dip in your score at first, it could benefit you over time. Though it’s worth noting that if you miss any payments on the new loan, your credit score could drop sharply.

What is the difference between debt management and debt consolidation?

Debt consolidation is not the only option for managing debt. One alternative to debt consolidation is creating a debt management plan (DMP) with assistance from a credit counseling agency.

A debt management plan is a formal agreement between a borrower and his or her creditors to repay debts over time. With a DMB, your monthly payments are usually based on your income and expenses, so you can make manageable payments that work for your budget.

An advantage of a DMP is that it may help you get out of debt faster than if you were making minimum payments on your own. Additionally, some creditors may agree to waive late fees or reduce interest rates during the duration of the plan.

What are simple ways to reduce debt?

Besides arranging a DMP, you can pay down debts by exploring a debt settlement. Debt settlements involve a negotiation process in which you work with a creditor to settle your debt for less than the full amount owed.

It can be a quicker and more cost-effective alternative to a debt consolidation loan, but it comes with risks. The main risk is that if you don’t pay off the negotiated amount, your creditor could charge you for the full balance owed.

No matter which approach you choose, it’s essential to make a budget and stick to it. When you know where your money is going, it can be much easier to cut back on unnecessary expenses and put more money toward paying off your debt.

The bottom line on your credit score and debt consolidation

So, what does debt consolidation do to your credit score? Debt consolidation can have both positive and negative impacts on your credit score.

On the positive side, consolidating your debt may help you get out of debt by allowing you to make a single monthly payment on a lower-interest loan. In turn, paying off your debts may improve your credit score by demonstrating to creditors that you’re a responsible borrower.

However, debt consolidation can temporarily lower your credit score because your credit report will receive a hard inquiry with each application for a loan or credit card. Additionally, there may be more fees upfront, and having all of your debt on one payment means that a missed payment can have even greater effects on your credit.

For more financial education, visit the Vital Card blog.