How Does Debt Consolidation Affect Your Credit?
Many Americans are dealing with debt. In fact, U.S. households currently hold nearly $18 trillion in debt — and $1.17 trillion in credit card debt alone.
If you’re in this cohort, debt consolidation may be an option to help. This strategy involves rolling all your debts into one single loan or credit card, allowing you to pay things off more easily and, often, at a lower interest rate, too.
But debt consolidation isn’t without its flaws — and it can affect your credit and future financial options as well. Are you considering debt consolidation to deal with your debts? Here’s how it could impact your credit.
What is debt consolidation?
Debt consolidation is a type of debt management strategy that essentially lumps all of your debts together, using one single financial product.
“Debt consolidation is an option when you’re overwhelmed by multiple debts,” says Steve Azoury, owner of Azoury Financial in Troy, Michigan. “It involves combining several debts into one loan to make life simpler and, hopefully, save money.”
Here’s how it works: Say you have five credit card balances and a personal loan. To consolidate these, you’d take out a debt consolidation loan — or, if you’re a homeowner, potentially a home equity loan or HELOC — and then use those funds to pay off your credit card balances and your personal loan balance. This would roll them all into the new loan, and you’d only have to make one monthly payment moving forward.
Ideally, the consolidation loan would also have a lower interest rate than what you were paying on your other balances. (Considering credit card rates are currently above 21%, this is likely nowadays). And with a lower rate, that also means lower monthly payments — which could help you free up some cash each month.
Does debt consolidation help your credit score?
One of the big perks of debt consolidation is that it can allow you to pay down your balances more quickly, especially if you’re able to reduce your interest rate. Assuming you can afford to put the same amount of money toward debts before and after consolidating your balances, reducing your rate would allow you to consistently direct more money toward the principal balance — rather than just interest.
“If the interest rate is lower on the new loan, it frees up more cash to pay down the debt faster,” says Stephan Shipe, owner of Scholar Financial Advising in Winston-Salem, North Carolina.
The total amount of debt you owe makes up 30% of your credit score, so as you pay down those balances, your credit score should increase over time.
Debt consolidation also “helps reduce the risk of missing payments,” Stipe says — another benefit that can help your credit score. (Payment history is 35% of your score, so missed payments can deliver a big blow to your credit — as much as 100 points or more, in some cases).
Does debt consolidation hurt your credit score?
Debt consolidation can hurt your credit, too. First, your credit score will take a light hit when you apply for your consolidation loan, as this requires a hard credit inquiry. (New credit inquiries account for 10% of your score).
“It can hurt your credit in the short term, as you’ll have this new line of credit on your report — the debt consolidation loan,” says Mike Chadwick, owner of Fiscal Wisdom Wealth Management in Canton, Connecticut.
Fortunately, credit bureau Experian estimates your score should drop less than five points and will usually bounce back up after a few months — as long as you stay on top of your payments.
Debt consolidation can also hurt your credit if you opt to close out your old credit card accounts after consolidating their balances. That’s because credit length — or how long you’ve had your accounts — makes up 15% of your score, and credit mix — or the variety of types of credit you have — accounts for another 10%. When you close a card or pay off a loan, it impacts both of these factors, especially if you’ve had the account for many years.
The importance of shopping around
If you do choose to pursue debt consolidation, make sure you explore your options. You can use a designated debt consolidation loan, a personal loan, a home equity loan or HELOC, or even another credit card if the rates are right.
You should also compare lenders, Azoury says.
“It’s always best to shop for rates and terms, as the right choice can save you thousands of dollars,” Azoury says. “The wrong choice can hurt.”
More from Money:
Struggling With Debt? Here Are 4 Options to Get Things Under Control
3 Smart Ways to Consolidate Debt
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