Debt Consolidation Loans: Good or Bad for Your Credit?
Seemingly simple questions can have complicated answers. "Do debt consolidation loans help or harm your credit?" is one such question. It looks like it is a yes or no question. Either debt consolidation loans help your credit or they hurt it.
It turns out that the question is more complex than it appears.
Different Types of Debt Consolidation Loans
One reason that the answer is complicated is that there are different types of debt consolidation loans.
To find the right solution, you need to weigh various factors. One important factor is how any solution will affect your credit.
“Do debt consolidation loans help or hurt your credit?” The answer is yes and no. Let’s take a look at how a debt consolidation loan hurts your credit score in the short term, but helps your credit score over the long haul.
What is Debt Consolidation?
Debt consolidation is combining multiple debts, usually from mulltiple 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 own retirement account
All of the above have some initial negative impact on your credit score from the credit inquiry the lender makes as part of your loan application, except for the loan from your retirement account. Borrowing from your retirement account requires no credit inquiry. There are definite potential downsides to borrowing from your retirement, 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, but no harm to the credit.
The other three options have different effects on your credit.
- A balance transfer is likely to harm your credit if you use a large percentage of the new cards credit limit to pay off your other cards. This harms your credit utilization on the new card, though will reduce your overall credit utilization.
- Using your home equity has risks, but should improve your credit. Downsides are increasing your mortgage payment and therefore increasing the risk that you can't make the payment. This puts your house at risk, if, for whatever reason, you are unable to make the new, higher mortgage payment. Another downside is turning unsecured debt into secured debt. None of those are abourt credit, however, and if you make your mortgage payment on time, plus lower your credit utilization by paying off your credit card debts, it will be good for your credit score.
- 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.
The impact on your credit score 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 whether debt consolidation loans are good for your credit or bad, is that "debt consolidation" can be used to mean more than the debt consolidation loan options reviewed above, all of which involve paying off your original debts with a new debt. Debt consolidation can be used to decscribe two debt relief 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 what you owe
- A debt management plan (DMP) offered by a Consumer Credit Counseling Service that 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 delinqeunt 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. This 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.
Both of these solutions are appropriate for certain consumers. If you are struggling to pay off debt and can't afford your current monthly payments, the standard debt consolidation loans are not likely to be a workable solution.
What is Your Credit Score Today?
When choosing the right debt consolidation loan or solution, your options are limited by your current credit score.
- An unsecured personal loan requires strong credit to get decent rates. It is possible to qualify for an unsecured personal loan with fair, or even poor credit, but rates can be in the range of 30% or higher. It is most often a good solution for borrowers with very strong credit.
- Balance transfers require very strong 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, too.
- 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 .
Any time that you are working to pay off debt, it is smart to look at all the available options. Your individual situation, like everyone's, has its own wrinkles. Your age, whether you have dependents, your job stability, how much you have in liquid savings or in less liquid assets, are all factors you should weigh.
Use the Bills.com Debt Pay Off Calculator to find the debt consolidation option that fits your goals and priorities, and has a payment that you can afford.
Credit impact, is another factor you should weigh, but weigh it appropriately. Don't make your financial decision based on whether debt consolidation will harm or hurt your credit, unless you know you have a strong need for good credit in the near future. For example, if you think you will sell your home and move to somewhere where you want to, and can afford to, buy another home, then you want to be very protective of your credit.