A debt consolidation loan can help you lower your monthly payment and help improve your credit, but only if you stick to a plan to pay down your debt.
If you have high-interest credit card balances on multiple accounts, just making those monthly payments can be so tough that you can’t afford the things you really need or want — much less save any money. It may also stress you out. In this situation, debt consolidation might be a smart decision. But before you get started, let’s dig in to understand how debt consolidation can affect your credit score.
Ways to consolidate your debt
The basic idea of debt consolidation is to merge multiple credit or loan balances into one new loan. Here are four ways you can consolidate debt depending on your credit and savings:
- Balance transfer credit cards — Some credit cards, called balance transfer cards, offer introductory periods when they charge low or no interest on balances that you transfer to the card within a set period of time. This gives you an opening to save on interest and make more progress paying off your debt.
- Personal loans — If you can get a personal loan with a lower interest rate, you can pay off your higher-interest credit card balances, which may allow you to pay off your debt faster.
- Home equity loan – With a home equity loan, homeowners who’ve built up equity in their home may be able to take out a loan using their home as collateral. These loans typically offer lower interest rates than credit cards or personal loans. But beware: If you don’t pay it back, you could lose your home.
Why consolidate your debts?
Consolidating your debt can save you money. If you have credit card debt that charges 20% or more in interest, consolidating into a new credit card or loan with a lower interest rate will save you money. Work out the costs for your specific debt to make sure you’ll save more than any fees you’ll pay for balance transfers.
It may also simplify your payments. When you have many accounts to manage, you are more likely to make a mistake and miss a payment. Missed and late payments can hurt your credit scores, so consolidating everything into one monthly payment might help protect your credit from a payment mishap.
How debt consolidation affects credit scores
When you consolidate debt, you pull several levers at once that help or harm your credit. Here are some short-term causes of a credit score drop when consolidating debt:
- New credit applications — The first possible damage to your credit scores can happen before you even consolidate: When you apply for that personal loan or balance transfer credit card, the lender will perform a hard inquiry on your credit, which will be visible to other lenders and may hurt your ability to get other forms of credit.
- New credit account — Opening a new credit account, such as a credit card or personal loan, temporarily lowers your credit score. Lenders look at new credit as a new risk, so your credit score usually has an additional temporary dip when taking out a new loan.
- Lower average age of credit — As your credit accounts get older and show a positive history of on-time payments, your credit score rises. If you use a consolidation loan to pay off your older credit accounts and close them, your ‘age of credit’ factor may drop to the age of your newest loan, with a corresponding drop in your credit score.
But it isn’t all bad. Here are some positives for your credit score from a debt consolidation:
- Lower credit utilisation rate — This percentage is a measure of how much of your available credit you’re using of your total available credit, and may fall when you open your new debt consolidation account because it will increase your available credit. Lower credit utilisation may counter some of the negative effects of opening a new account that we mentioned above.
- Improved payment history — It will take some time, but if you make payments to your new loan on time you may see your credit score slowly rise. Your payment history is the biggest factor in your credit score, so you should always try to pay on time and in full – or in the case of a credit card, at least the monthly minimum payments, and more if you can.
Bottom line
Consolidating your debt into a new, lower-interest loan — a balance transfer credit card, personal loan or home equity loan — may hurt your credit score in the short- or medium term. But if you make regular, on-time payments on that consolidation loan and pay it off in a reasonable amount of time, your credit score should recover and may even improve over the long run as you get rid of debt faster and establish a sound payment history. Before you apply, be sure to consider all the pros and cons of a debt consolidation loan.