Does Debt Consolidation Affect Credit Score?
Debt consolidation is a strong approach relying on having more than one credit, which becomes a problem for some people. However, the question most people have is the effect of this step on credit scores. Should I pay off debt with a consolidation loan, or lessen my credit utilization ratio, which is likely to help me, or hurt me? Several issues come into play when determining the answer to this question.
Here, we’ll discuss the details of what happens to your credit score when you consolidate your debt, key factors to take into consideration, and ways to get the best from consolidating your debts.
What is Debt Consolidation?
Debt consolidation is the act of combining loans so that an individual has to pay only a single debt which is usually a large one. This can be achieved in a number of ways such as taking out a debt consolidation loan, applying for a balance transfer credit card or engaging the services of a debt management program. What is generally sought is to make payment to the debt easier which can often come with the additional advantage of cheaper rates.
The most common forms of debt consolidation are:
- Debt Consolidation Loan: This is a loan that is meant for curing many other debts at an agreed period of time.
- Balance Transfer Credit Card: Paying off several credit cards which have a high interest on them and then transferring the balances to another credit card that has a lower interest rate.
- Debt Management Plan: Having debts consolidated through a credit counselor and then paying the credit counselor who would then pay the various creditors on your behalf on a monthly basis.
Though consolidation helps in reducing the number of repayments and sometimes even the interest rates, it is necessary to know about the effect of consolidation over the credit score.
How Debt Consolidation Affects Your Credit Score
In general, debt consolidation has pros and cons and the impact that it will have on your credit rating will depend on how they are done. It is time for us to look at both scenarios more closely.
Positive Effects on Your Credit Score
- Simplifies Your Payments
Discussed here are some reasons as to why, when you bring all your debts into one loan or payment, you manage your money better. One can pay less if the payment is due, thus if the payment process is made easier it may be hard for the payment to be missed. Payments made on time will always have good impacts on the credit score in the future. - Lowers Credit Utilization Ratio
The credit utilization ratio which is the credit being used at a certain point in time to the total credit line available is one of the most important factors that determine your credit score. That means, by paying off your debts through consolidation, you could lower your ratio, possibly when paying off your credit card balances with an outstanding loan or another card with a larger credit limit. It has also been shown that a reduction in credit utilization can cause an improvement to credit score. - Creates a Positive Payment History
When it comes to consolidated debt, the idea is that the new loan or from the balance transfer, responsible payments made on time can help construct credit payment history. Repayment history contributes to the majority of the credit score therefore paying off the consolidated debt on time will ultimately improve your score.
Negative Effects on Your Credit Score
- A New Credit Inquiry
When you fill out the application for a debt consolidation loan or balance transfer card, such a check is considered to be a hard inquiry on your score. This inquiry may reduce your credit score for a little while as you wait for the results. However, the effect is rarely profound and rather lasts only for a short period. - Risk of More Debt
While debt is incurred to pay for various debts surfacing from expenses incurred, consolidating the loans denies the source of the spending habits, which will result in accumulation of more debts. Credit scores are also likely to be affected negatively because credit utilization as well as having more credit accounts will increase if you consolidate credit cards with a loan and use the money to pay off the cards only to charge up again. - Impact of Closing Accounts
If you close old credit card accounts after transferring balances to a new card or loan, your credit score might be negatively impacted. This is because closing accounts can reduce your overall credit limit, increasing your credit utilization ratio. Additionally, closing accounts may also shorten your credit history, which can hurt your score.
Factors to Consider Before Consolidating Debt
If you’re considering debt consolidation it’s important that you understand the pros and cons of this maneuver before proceeding. Here are some factors to consider:
- Interest Rates
Make sure the new loan or balance transfer credit card gives a lower interest rate as compared to your current debts. Otherwise, the elimination of such options may not bring any savings to the table for consolidating. - Fees and Costs
Still, there are some ways to consolidate your debt where you will be charged some fees. This can be in the range of balance transfer fee of 3-5% of the amount of balance that you transfer to the card. When comparing your choices please ensure you include these extra prices. - Commitment to Paying Off Debt
You should also know that consolidating your debt is not a way of eradicating your debt; you just change the way it is arranged. You still need to exercise some restraint in repaying the money and ensure that one does not borrow too many times. Otherwise, you might be in a worse condition as a financial standpoint is concerned. - Credit Score Impact
Speaking of drawbacks, it should be mentioned that the consolidation of debts may for a short time cause the reduction of the credit score because of the multiple inquiries into the credit history or the closure of credit accounts. But, after paying one’s dues on time on a new loan or credit card it is expected that one’s rating will improve.
How to Minimize Negative Impact on Credit Score
If you’re concerned about the potential negative effects on your credit score, here are a few steps you can take to minimize the damage:
- Make Timely Payments
Important as it may be, never forget to pay your bills on time irrespective of whichever way you take the debt consolidation strategy. Unpaid payments will decrease your credit score by a considerable margin, and that is why automating payments is a good idea. - Keep Old Accounts Open
If there are some good old credit card accounts after balance transfers, it is better not to shut those accounts. This will enable one to preserve their credit utilization ratio and prevent the accumulation of credit history. - Avoid New Debt
To enhance the effectiveness of paying off the consolidated loan, one should avoid the habit of borrowing more loans. Debt consolidation is meant to ease a person’s financial situation and not provide an opportunity for a person to further borrow. - Monitor Your Credit Report
It is also important to keep on checking your credit report in order to see the impact that your debt consolidation is having. You are very likely to use a tool or a service to monitor your credit score on a regular basis and it does not have to cost you a dollar.
Is Debt Consolidation Right for You?
As mentioned earlier, debt consolidation is not a one time solution for the debts people incur. This might make sense for people with several high-interest obligations, a high credit utilization rate, and a preference for more straightforward and reasonable payment. But, one should not be lazy and default on payments of consolidated debts; this is another disadvantage since some people will go back to their irresponsible spending spree.
Although there are many benefits that may come with the use of debt consolidation, you should seek the help of an expert like a financial advisor or credit counselor in order to know whether consolidation of debts will work in your favor or not.
Conclusion
Thus, the question is does debt consolidation impact on credit score? The answer is ‘Yes,’ but whether or not the latter has a positive or negative impact may well depend on how the former is ‘managed.’
Debt consolidation tends to lower one’s credit score slightly in the short run resulting from hard inquiries account closure. But if done properly, debt consolidation means simplifying your payment method, reducing your credit utilization ratio and subsequently posting a better score on your credit report than before.
Debt consolidation is often a good idea in cases when people have multiple debts that are hard to handle, yet what is important is to combine them following a definite plan and keeping away from additional debts. In case of doubts, consulting an expert is the best way to go if one is to make the right financial decision.
For more detailed advice on managing debt, check out this debt consolidation guide.
By understanding how debt consolidation affects your credit score, you can make an informed decision that will set you on the path toward better financial health.