Does Debt Consolidation Hurt Your Credit?

You’ve seen TV commercials about the virtues of consolidating your debts, but there’s one nagging issue. Is it going to hurt your credit?

The last move you want to make is one that will make your financial situation worse. You don’t want more debt, and you don’t want your credit destroyed.

Debt consolidation combines your credit cards bills into one manageable monthly payment, one with a better interest rate than you have now. Done correctly, the process has a positive effect on your long-term credit.

You have several ways to tackle your debt. The most common are debt management plans, personal loans and credit card balance transfers, but you can consider a home equity loan, a line of credit (HELOC) or taking out a loan against your 401(k) loan.

Each has different effects on your short- and long-term credit scores.

How Does Debt Consolidation Work?

Debt consolidation works when you succeed in getting a lower interest rate than the one you have now with the combined terms of your creditors. A lower interest rate saves you the most money.

To move forward, you must choose a debt consolidation method. The most preferred ways are a personal loan, a home-equity line of credit, a home-equity loan or a low-interest credit card that allows balance transfers.

You can also borrow against your 401(k)-retirement plan but consider that a last resort. You’ve invested time and money in your 401(k), and borrowing against it has too many negative long-term consequences to pay off personal debt.

If your debts are on multiple credit cards, obtaining a no-interest credit card that takes balance transfers can be a winner — especially if you’re moving balances off of high-interest credit cards.

However, you want to be aware that when the 0% introductory rate ends on that new card, the future rate isn’t higher than what you’re already dealing with. This is an important detail.

How Much Does Debt Consolidation Hurt Your Credit Score?

At the start, most debt consolidation methods have a negative effect on your credit score. They lower your score temporarily for several reasons. For example, debt management plans ask you to quit using your credit cards. If you cancel a card, that reduces the amount of credit you have available, and that can lower your credit score.

When you apply for a consolidation loan, lenders make a so-called “hard inquiry” about your credit, which lowers your score by a few points. If you’re shopping for the best loan and you incur several inquiries in a short span, usually 14 to 45 days, credit bureaus treat it as one inquiry.

On the other hand, if you have credit inquiries spread over a longer period, credit bureaus see them as desperate attempts (by you) to gain credit. This affects your credit score more negatively.

“Consolidating debts does not have a direct impact on your credit scores, but it can be a helpful way to protect your financial standing,” says Rod Griffin, senior director of consumer education and advocacy for Experian, one of the three major credit bureaus. “Paying off multiple debts with a single, larger loan with a lower interest rate and perhaps longer repayment period can reduce the monthly payment amount. As a result, you may be better able to manage payments and ensure they are on time, protecting your credit history. Similarly, consolidating credit card debts may help you improve your credit scores.”

Other effects of debt consolidation depend on the method. Loans and balance transfers have many potential negative effects. Debt management plans have little impact.

No matter which method you choose, the biggest factor in how debt consolidation affects your credit is how you treat the credit you already have. Making late payments on loans, credit cards and other monthly bills hurts your credit score. A payment that’s 30 days late stays on your credit report for seven years.

The best thing you can do to maintain good credit or repair poor credit is to make all your payments on time.

Not accumulating more debt after making a debt consolidation move is also important. Don’t think that paying off credit cards bills with a consolidation loan means you’re free to go back using the cards recklessly. That’s inviting more trouble.

When Consolidating Debt Makes Sense

Consolidating debt makes the most sense when you’re spending too much money on interest charges from your various creditors. Interest rates on credit-card balances are notoriously high — 15% on the low end to more than 27% on the high end.

That’s one reason it can be so hard to pay off the balance. Your total regrows quickly.

When you move your debt to a low-interest vehicle, be it a balance-transfer credit card or a consolidation loan, you’ll save money in Month 1.

Another time when debt consolidation makes sense is when you want to simplify things. You will make only one debt payment a month — and you won’t have to keep track of multiple due dates and amounts, the sort of mental juggling that wears on you emotionally.

You’ll reduce your debt and your stress level at the same time.

Credit Factors Affected by Debt Consolidation

Many debt consolidation options will have minor negative impacts on credit, but remember, they’re temporary. They will also have long-term positive effects.

The three major credit reporting bureaus — Experian, Equifax, and TransUnion — take several things into account when determining a credit score.

One type of consolidation that can be extremely detrimental to your credit score is debt settlement, a process where you negotiate with creditors to pay less than what you owe. Credit rating bureaus take a dim view of debt settlement and the drop in your credit score will reflect that.

“When you pay a debt settlement firm to negotiate reduced debt repayment, the accounts will be reported as ‘settled for less than agreed’ in your credit history,” Experian’s Griffin says. “Any debt not paid in full as agreed will hurt your credit scores. The only ‘consolidation’ in these types of agreements is that you consolidate your payments into one check that is given to the debt settlement firm, which then distributes the funds to your creditors after taking out a share for itself.”

Negative Effects on Credit

• Credit applications trigger hard inquiries that temporarily lower credit scores by a few points; several applications over an extended period will have a greater effect.
• A new account has no payment history until on-time payments are made consistently.
• The average age of credit accounts drops with a new account. The older the average, the better.
• If you transfer debt to a card with a lower credit limit, the credit utilization rate will increase, and that will lower your credit score.

Positive Effects on Credit

• The credit utilization rate will decrease if you transfer debt to a card with a higher limit, or if you pay off credit balance with a loan.
• On-time payment history will always strengthen your credit score in the long run.

Consolidating Debt with a Personal Loan

A personal loan is a good way to consolidate debt if you have a good credit score, 680 or higher. The lower your credit score, the harder it is to get a loan that makes financial sense, if you can get one at all. High interest rates and fees can erase any cost savings.

To restrict the negative impact on credit, borrow only the money you need to pay your debt down. If you take out more money than you need, you’re only increasing your overall debt, and that could end up hurting you.

Also, remember: If you don’t want the loan to have a negative impact on your credit, be financially responsible.

“If you get a consolidation loan and keep making more purchases with credit, you probably won’t succeed in paying down your debt,” the Consumer Financial Protection Bureau advises.

As with everything, there are pros and cons to consolidating debt with a personal loan.

Pros of Debt Consolidation Loans

• Interest should be lower than what was being paid for credit card debt.
• Combines several bill payments into one monthly payment.
• Payments are the same amount every month and are for a fixed amount of time, usually 3-5 years.
• They don’t need as high a credit score as balance transfer cards.
• They can decrease the credit utilization ratio.
• They are unsecured, unlike a home equity loan or other collateral-based loans.
• Some come with special offers, like direct payment to creditors, free credit score monitoring, hardship flexibility and more.

Cons of Debt Consolidation Loans

• Must have a good credit score to get the best interest rate.
• Loan fees may apply.
• Prepayment and exit fees can make the loan cost more than expected.
• If it’s used to pay off credit cards, and the cards are still in use, it could increase debt.

» More About: The Pros and Cons of Debt Consolidation

Consolidating Debt with a Balance Transfer

Balance transfers, in which credit card balances transfer to a lower-interest or zero-interest card, works if you have a credit score of 700 or higher.

If you fall below 700, you may not qualify for the card. Or if you do, it could end up costing you money in fees or a shorter introductory period for the low interest rate. If you get to the end of the introductory rate and you still have a high credit card balance, you could be back to where you started. Or worse.

Pros of a Balance Transfer

• You get a lower initial interest rate, usually 0% APR for those with good to excellent credit scores.
• You can move credit card debt onto a lower-interest card with one monthly payment.
• You can improve your credit by lowering your credit utilization rate.

Cons of Balance Transfer

• You can’t transfer balances from one card to another if the cards are from the same bank.
• Most cards charge a transfer fee of 3%-5%. So, if you’re transferring $5,000, it will cost $150-$250.
• You must complete most transfers within 60 days of opening the account, or you miss the 0% APR deal.
• The low interest rate is for a limited time — usually 6-18 months — then the rate increases to nearly 24% on the remaining balance.
• If you use the card for purchases, the 0% rate may not apply.
• Card issuers usually limit the amount that you can transfer to a percentage of total credit limit or specific dollar amount. They also include fees in the calculation.
• Transfers can hurt your credit score if you keep using the cards where you transfer balances from. It raises your debt and credit utilization amounts.

» More About: How to Consolidate Debt Without Hurting Credit

Other Ways to Consolidate Debt

There are other ways to consolidate debt, some of which have little or no negative impact on your credit score. Some of them even have positive long-term positive benefits if you pay down your debt.

Debt Management Plans

A debt management plan merges your debt with little immediate negative impact on credit and potential long-term positive impact. It doesn’t involve taking out a loan or increasing credit, and your credit score is not an eligibility factor.

A nonprofit debt management agency, has agreements with banks to reduce the interest rate on your cards to somewhere around 8%. You make a fixed monthly payment to the agency for 3-5 years and they distribute the money to your lenders.

The credit bureaus note your plan on your credit report, but the notes come off once you pay off your debt. Closing credit card accounts may slightly lower a credit score, but prompt, consistent payment of bills will improve your credit rating. Debt management plans come with a monthly administrative fee.

Home Equity Loan or Line of Credit

Homeowners can use the equity in the home for a one-time, lump-sum loan or line of credit (HELOC) to merge debt. It has the same impact on your credit score as any other loan, meaning your score will improve if you make on-time payments and will suffer if you miss payment. Since you’re using your house for collateral, a worst-case scenario is that you lose your house if you don’t make on-time payments. A home equity loan is similar, but is a lump sum payment rather than a revolving line of credit.

Borrowing from Your 401(k)

A 401(k) loan is a loan you make to yourself from your 401(k) retirement savings plan. It has no effect on your credit. It will, however, cost you money.

If you withdraw the money before turning 59 and a half, you will be assessed a 10% penalty and then taxed on the amount you withdraw. You’re also not accruing interest on what was previously tax-free income you were investing in your retirement. It’s not a good option, so exhaust other ones first.

Bankruptcy

Filing for bankruptcy is an extreme measure and only a choice if there is no other solution. It has a huge negative impact on your credit. Your credit score drops anywhere from 100-250 points. A Chapter 7 bankruptcy stays on your credit report for 10 years. A Chapter 13 bankruptcy stays on your credit report for seven years. Both can have a negative impact on buying a house, renting an apartment, buying a car and more.

How to Minimize Impact of Debt Consolidation on Credit

When you press forward with a debt consolidation strategy, have a game plan. You want to minimize the impact your actions will have on your credit.

These tactics aren’t rocket science, but they are important:

• Make your payments on time every month: This is the most important thing you can do. Credit bureaus and your future creditors want evidence of your financial responsibility. Months of on-time payments show consistency and integrity.
• Don’t close your other accounts right away: This is especially true if one debt you’re combining comes from a credit card you have used for many years. Credit bureaus reward people who have credit accounts with a lot of history on them. So, keep those accounts open for now.
• Buckle down and pay off your debt: Although you will probably have many months to pay off your consolidated loan or balance-transfer credit card, work hard to get the balance to zero as fast as you can. The quicker you can get that done, the faster and higher your credit scores will climb.
• Monitor your credit scores: Heck, make a game of it and track your scores. You’ll see your scores drop within a few months, but soon enough you’ll enjoy them creeping back up into respectability or even higher.
• Don’t apply for a new credit card or loan: Once you have your debt consolidation plan in place, let things settle. Trying to open a new credit account is a warning sign about you to lenders.

How Debt Consolidation Can Help Your Credit

If done right, debt consolidation will have a positive effect on your credit. It shrinks your debt and sets a foundation for consistent on-time payments, which can send your credit score soaring.

But where do you start?

“If you’re having trouble with credit, consider contacting a credit counselor,” before jumping into debt consolidation, the Consumer Financial Protection Bureau advises.

Working with an accredited credit counselor is a good way to explore debt relief options and decide what the best way to consolidate debt is for your financial situation.

Accredited nonprofit credit counseling agencies offer free counseling. Counselors will help you review your budget, evaluate debt consolidation alternatives, and suggest solutions.

Before connecting with a counselor, do your homework online.

Major credit bureaus can also help. Experian, for instance, has an online credit-matching tool that can show you current credit offers that fit your financial profile.

» Check out our list of the top credit counseling agencies