As your debt continues to pile up, it’s easy to feel as though your options are limited.
Managing multiple debts and payment due dates can add to the stress of your already strained finances.
However, one thing you can do to help alleviate some of the financial pressure is to consolidate your debt into one loan repayment plan.
There are many benefits to debt consolidation, but there are also a few drawbacks. Here’s how consolidation can hurt, or help, your credit score.
What is Debt Consolidation?
When you’re striving to pay off debt, consolidating multiple loans and credit cards into one account, can be an excellent strategy.
Debt consolidation is the process of combining multiple debts into one streamlined payment, often with a much lower interest rate and smaller monthly amount.
Many different types of loans can be used to consolidate other debts, such as peer-to-peer lending services, personal loans, and even balance transfers from other credit cards.
You can apply for many of these debt consolidation options online, or even check with your local bank or credit union.
Shop around before finalizing which consolidation loan you want to use, as the goal is to find a loan that offers a lower interest rate than you’re currently paying.
Plus, any additional fees from the loan origination process need to be offset by the money you’re saving in the future.
This brings us to the next point; does debt consolidation hurt your credit score?
All About Credit Scores
When you apply for a debt consolidation loan, a lender will review your credit report to make an educated decision about whether or not you’re a good candidate to repay the funds.
After reviewing your overall credit, they will look at your credit score, also known as a FICO score, to determine your creditworthiness.
A FICO score is used by more than 90% of major U.S. lenders and is a way to assign consumers a number that’s equal to the amount of their credit risk.
Financial institutions use a credit score in their decision-making process to determine whether or not to approve you for a loan. This applies to consolidation loans, too.
The exact formula for calculating your credit score is hidden, but there are five main factors.
All five of these credit score factors have various percentages of impact but are nonetheless essential for obtaining a healthy credit history.
FICO Credit Score Factors and Their Percentages
|FICO credit score factors||Percentage weight on credit score:||What it means:|
|Payment history||35%||Your track record when it comes to making (at least) the minimum payment by the due date.|
|Amounts owed||30%||How much of your borrowing potential is actually being used. Determined by dividing total debt by total credit limits.|
|Length of credit history||15%||The average age of your active credit lines. Longer histories tend to show responsibility with credit.|
|Credit mix||10%||The different types of active credit lines that you handle (e.g., mortgage, credit cards, students loans, etc.)|
|New credit||10%||The new lines of credit that you've requested. New credit applications tend to hurt you score temporarily. Learn more about FICO credit score|
As you can see, having a good mix of credit is something that will have a positive effect on your credit history.
In the event you apply for an installment loan such as a personal loan, to consolidate your debts, this will add to the various types of credit you have on your report. This can increase your FICO score in just a few months.
On the flip side, any time you obtain any type of new credit, whether it’s a credit card or installment loan, your credit score may temporarily drop.
The good news, though, is that if you continue to repay your debts on time, it will bounce back fairly quickly.
How Debt Consolidation Can Hurt Your Credit
Generally speaking, moving debt around from one account to another does have a significant impact on your credit score.
The amount of debt you have remains the same, that is until you start paying it down.
Whether or not debt consolidation can hurt your credit score, also depends on your credit utilization or the amount of debt you have to the lines of credit available.
Typically, the process of consolidating debt means transferring what you owe from one account to another.
After this, many individuals will close the old accounts, which can temporarily hurt your credit.
Why? Reducing the amount of credit you have available increases your debt-to-credit ratio and increases your overall credit utilization. This will cause your credit score to go down.
Another negative thing that can happen when you close a credit account is that the age of your accounts stops growing.
As one of the five main factors that impacts your credit usage, having a lengthy credit history is one of them.
However, when you close an account after consolidating your debts, the average age of accounts will be reduced causing your credit score to decrease.
Also, if you open a new credit line for the purpose of consolidation, that new loan application is considered a “hard pull” that can ding your credit slightly.
When you apply for debt consolidation or any other type of new credit, you are giving lenders permission to place a “hard inquiry” on your credit report.
This gives them the ability to review your report and weigh in on your FICO score.
Doing this, however, often equals a negative effect on your credit score causing it to decrease, especially if you have multiple hard pulls in a short amount of time.
Unlike a “soft inquiry” that does not have a long-term effect on your credit, a hard inquiry can stay on your credit report for many years.
This is why it’s important to review various consolidation loans and financial companies before making your final decision.
Applying for too many loans at once can cause your credit score to take a big hit.
Is Debt Consolidation Still Worth It?
Even if your credit takes a small hit in the short term, is debt consolidation still worth it?
Yes, but only if your overarching purpose is to eliminate debt and strive for a healthier financial life.
Choosing to combine your debts into one monthly payment can be a smart financial move.
Just be sure to do your research with each consolidation company so you can get the best interest rate and terms possible.
It’s also important that you keep your accounts open after you consolidate, although you can cut up any credit cards to restrict using them in the future.
However, the good news if you must close credit accounts, is that your credit score can bounce back and the negative impact won’t have a long-term effect.
Debt consolidation is an excellent solution for any long-term debt repayment plan with the hopes of establishing healthier financial habits.
When combined with smart money strategies, such as reducing your spending and not taking on more debt, consolidation can save you a good amount of time and money.
Not only will you be able to streamline your monthly payments into one, but you can also get out of debt faster by paying less interest to lenders.
When done the right way, debt consolidation can have a minimal impact on your credit score over the long term.