- 5 min read
- Debt consolidation has both negative and positive impacts on your credit score.
- In the short term, a hard inquiry can hurt your credit.
- The most crucial factor is to make sure your payments are affordable.
Debt Consolidation Affects Your Credit
Here are the main ways debt consolidation affects your credit:
- A hard credit inquiry can temporarily hurt your credit.
- If you take a debt consolidation loan and pay off your credit cards, your credit utilization will go down, and your credit score will rise.
- If you make your payments on time, then in the long-run, your credit will increase.
Different types of debt consolidation and your credit
Debt consolidation is combining multiple debts, usually from multiple creditors, into one debt with a new creditor. Here are some different ways that you can consolidate debt.
- A personal loan you use to pay off other debts
- A cash-out refinance or home equity mortgage loan that rolls your debts into your mortgage payment
- A balance transfer that moves balances from different cards to a new credit card at a low, initial interest rate
- A loan you take from your retirement account
You can shop around with online lenders and get quotes without hurting your credit score. Lenders can pre-qualify you for a debt consolidation loan using a soft pull. However, to get approved and take a loan, the first three options require a hard credit pull that negatively affects your credit, at least in the short-term.
Debt Consolidation Loan
A personal loan will reduce your credit utilization, too, and boost your score. You can also improve your score by increasing the variety of credit accounts, especially if you have no installment loans that currently report to the bureau. In general, the higher your credit, the better rates you get on your debt consolidation loan. However, even if you have bad credit, consider a debt consolidation loan if the overall interest rate is lower than your current credit cards. The joint effect of on-time payments and lowering your overall credit utilization will improve your credit.
Cash-out refinance Loan
Using your home equity has risks, but should improve your credit. Mortgages have extended payment terms and lower monthly payments. A great reason to consider this debt consolidation option is to create affordable monthly payments. The main factor in your credit score is timely payments. Also, a mortgage lowers your credit utilization by paying off your credit card debts and increases your credit score.
In order to benefit from a balance transfer, you need excellent credit. Don't forget to check the terms and the length of the "teaser" introductory rates. Also, consider the affordability of the balance transfer fees. A balance transfer is likely to harm your credit if you use a large percentage of the new card's credit limit to pay off your other cards. If you use your balance card transfer wisely, you will both save money and increase your credit score.
Retirement account loan
Borrowing from your retirement account requires no credit inquiry. While there is no harm to your credit, there are definite potential downsides to a 401k loan, such as potential tax penalties and liabilities if you don't pay it back as agreed and slowing down the growth of your retirement funds.
Your credit score's impact is not the primary reason you should choose any of these debt consolidation options. Make your choice based on what can get you out of debt at a lower or more affordable monthly cost.
Debt Consolidation Can Have Multiple Meanings
Another source of confusion in assessing how debt consolidation affects your credit is that "debt consolidation" is used to mean more than the debt consolidation loan options reviewed above, all of which involve paying off your original debts with new debt. Debt consolidation is also used to describe two debt solutions that don't pay off your current debts but consolidate your payments, so you are working to resolve your debts while making one monthly payment. These two options are::
- Debt settlement, where you may be able to pay off your debts at a fraction of your balance.
- A debt management plan (DMP) offered by a Consumer Credit Counseling Service can reduce your interest rates and shorten the time it takes to get out of debt.
Debt settlement hurts your credit in the short-term. Creditors are willing to settle debts only when they have gone delinquent, and the delinquencies are reported to the credit bureaus and harm your credit score.
A credit counseling service's debt management plan requires you to stop using credit and often close all the accounts you enroll. The consequence is that it hits your credit utilization, so even though the notation that your accounts are being managed by a third-party doesn't directly lower your score, the practical effects of the program will.
If you are in financial hardship and less concerned about your credit's negative impact, then these are debt consolidation options to consider.
Debt consolidation: How your credit affects your options
When choosing the right debt consolidation solution, your options are limited by your current credit score.
- An unsecured personal loan requires excellent credit to get the best rates. It is possible to qualify for an unsecured personal loan with fair or even poor credit, but rates can be 30% or higher.
- Balance transfers require solid credit. They are also only a good option for you if you can pay down the debt significantly during the period the interest rate is low. Shop around to find the lowest rate for the longest time and pay attention to the fees.
- Using the equity in your home will generally have lower rates than a personal loan, even for borrowers with credit scores above 620, as long as they are current on their mortgage and have sufficient income to make the new mortgage payment.
- Borrowing from your retirement has no credit requirements
Your credit is essential in determining the type of options available and how much they cost. However, when choosing a debt consolidation options, make sure the payments are affordable. That is the most significant consideration in how debt consolidation affects your credit.
Debt is used to buy a home, pay for bills, buy a car, or pay for a college education. According to the NY Federal Reserve total household debt as of Q3 2023 was $17.291 trillion. Auto loan debt was $1.595 trillion and credit card was $1.079 trillion.
According to data gathered by Urban.org from a sample of credit reports, about 26% of people in the US have some kind of debt in collections. The median debt in collections is $1,739. Student loans and auto loans are common types of debt. Of people holding student debt, approximately 10% had student loans in collections. The national Auto/Retail debt delinquency rate was 4%.
Collection and delinquency rates vary by state. For example, in Alaska, 13% have student loan debt. Of those holding student loan debt, 8% are in default. Auto/retail loan delinquency rate is 2%.
Avoiding collections isn’t always possible. A sudden loss of employment, death in the family, or sickness can lead to financial hardship. Fortunately, there are many ways to deal with debt including an aggressive payment plan, debt consolidation loan, or a negotiated settlement.