Does Debt Consolidation Improve Your Credit Score?

If you find yourself having trouble with monthly payments and are accumulating a large debt balance, debt consolidation may be the right solution for you. Under this plan, you will combine all of your outstanding debts into one monthly payment. The goal behind consolidation is to reduce the interest you owe, and as a result lower your payments, so you can begin making those payments on time and begin to save money.

However, when deciding whether to consolidate your debts, it is important to consider how that might affect you in other ways, notably your credit score. In this article, we will go over how debt consolidation can affect your credit scores and review best practices to ensure that consolidation is beneficial to you in both the short and the long term.

Ways to consolidate your debt

Depending on the amount you owe, your credit score, and your monthly disposable income, the best way to go about debt consolidation may change. Here are five ways that you can consolidate debt depending on your financial situation:

• Balance transfer: A credit card balance transfer allows you to move all of your debt from different credit cards onto one card. These are specifically called balance transfer cards and they offer a 0% introductory APR for at least a year. This gives you an opportunity to save on interest and therefore make more progress paying off your debt. You can access the link here for a list of the current best balance transfer cards
• Personal loans: This is another option if you are seeking to consolidate your debt. If you are to get a personal loan with a lower interest rate, you can pay off your higher-interest credit card balances, allowing you to more quickly tackle your debt
• Retirement account loans: You also may be able to take a loan from your retirement account to consolidate and pay off debt. Importantly, make sure that you pay back the amount in accordance with your specific retirement plan’s rules or you may face added costs
• Home equity loan or line of credit: You may also be able to take out a loan using your home as collateral. With a home equity loan or home equity line of credit, you may be offered a lower interest rate than on your credit cards or personal loans. However, keep in mind that it is generally not financially prudent to replace unsecured debt with secured debt because you could lose your home if you are unable to make the payments.
• Debt Management Program: This is a program where professionals will assist you with your consolidation and set you up on a repayment plan. They are even able to negotiate with credit card issuers to help you lower your interest rates. If the previous 4 methods do not work for you, and you would prefer some help from certified counselors, a debt management program may be best for you.

How debt consolidation affects credit scores

When you consolidate debt, your credit score will likely be harmed in the immediate term for a few reasons. First, when you apply for that personal loan or for a balance transfer card, the lender will perform a rigorous examination of your credit, which may lower your credit before you even consolidate. Second, opening a new credit account temporarily lowers your credit scores, as lenders typically look at new credit as a new risk. Finally, as your credit accounts get older and show more history of on-time payments, your credit scores rise. Therefore, consolidating your debt will lower the average age of your credit, and in turn lower your credit score. 

However, these effects are all experiences in the short term. Debt consolidation is not all bad and can even have positive impacts on your credit in the long run. Consolidation will lower your credit utilization, which measures the amount of your credit limit that is being used and accounts for 30% of your credit score, causing your credit score to rise. And if you make payments on your new loan on time, your credit score will also rise. Payment history is the biggest factor in determining your credit score, and consolidation should make this easier for you by providing you with a single and smaller payment. As long as you make your payments on time and do not incur more debt, consolidation will benefit you in the long term and raise your credit score.

Conclusion

Consolidating your debt into a new, lower-interest loan, with the help of a balance transfer credit card, a personal loan or a home equity loan may hurt your credit scores in the short term. However, if you ride the course and make regular and on-time payments on that consolidation loan, your credit scores should not only recover but also improve over the long run, as you get rid of debt more quickly and establish a more sound and reliable payment history.