How Debt Consolidation Affects Your Credit

When debt piles up, you have several options for paying it back, including debt consolidation.

What is debt consolidation?

Debt consolidation means taking out one new loan large enough to repay some or all of your outstanding debt. You get the money, pay off your accounts, and then make a single monthly payment to pay off the new debt.

Debt consolidation can be accomplished in several different ways. Debt relief loans are one. You can also take a loan from your bank, a home equity loan (or a cash-out refinance) from your mortgage lender, or you can open a new credit card and transfer the balances over. The latter might come with a zero percent introductory interest rate, giving you several months or more to pay down your balance interest-free.

How debt consolidation affects your credit

The way debt consolidation affects your credit depends on the various options you choose.

Whether you opt for a loan or a credit card, you’re applying for new credit and that means a “hard” inquiry into your credit. Any time that happens, your score takes a dip.

Your credit score partly depends on your credit utilization – the amount of debt you carry as compared to the total amount of debt available to you. If all of your credit cards are maxed out, opening a new one increases your available debt and causes your utilization ratio to go down, and that could help your score. But your score will take a ding any time you carry a high balance on any one card. So if you transfer multiple balances to a single card and get close to (or reach) your credit limit, your score will suffer even if your other cards are paid off.

If you consolidate by taking a personal loan to pay off your credit cards, your utilization ratio could go down, causing your score to go up. For this to work, you need to leave the credit card accounts open after you pay them off. But your credit rating could go down if an underwriter has cause for concern that you could easily rack up new debt on the open and now balance-free credit cards (many people do).

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Protect your credit

If you are considering using a debt relief or debt consolidation company, arm yourself with information. For a fee, they negotiate with your creditors on your behalf, resulting in lower balances or interest rates. Legitimate debt relief companies will obtain a written agreement from each one of your creditors, detailing the terms of the agreement, your obligations, and what will be reported to the credit bureaus. In some cases, if your balances are lowered the creditor might report bad debt or a charge-off, which will negatively impact your credit history and score. Also keep in mind that debt relief companies generally charge higher interest rates than your bank or mortgage lender, particularly if you have less than stellar credit. So you might not save much in the long run, especially once you factor in fees. It’s up to you to do the math.

A huge portion of your credit score is based on your payment history. No matter what, make your payments every month, on time, including on any new consolidation debt.

Should you consolidate?

The key to debt consolidation is to avoid taking on new debt. If you borrow money, pay off your credit cards and then charge them back up again, you’re in worse shape than ever. If there is any chance that you might do this, or if you find yourself doing it after you obtain the consolidation loan, stop using the cards and just close the accounts. Your credit score will suffer, but your finances will thrive. Your score will come back up over time, and by then you’ll have learned valuable lessons about racking up too much debt.

Start by getting professional advice from a credit counselor. Visit the National Foundation for Credit Counseling to find a professional counselor in your area who will provide you with a free or low-cost consultation and help you devise a plan to get out of debt. The counselor might even help you negotiate your own agreements with creditors. If you develop and follow a get-out-of-debt plan with the help of a counselor (as opposed to consolidating your debt), your credit score will inevitably rise over time, as you make on-time payments and reduce your overall debt load. You’ll also avoid the hit to your score that comes with the new hard inquiry we talked about earlier.

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Slow and steady wins the race. Good luck.