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How Does Debt Consolidation Affect Your Credit Score?

How Does Debt Consolidation Affect Your Credit Score?
Jason Steele
Jason SteeleUpdated March 13, 2023
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Editor’s note: Lantern by SoFi seeks to provide content that is objective, independent and accurate. Writers are separate from our business operation and do not receive direct compensation from advertisers or partners. Read more about our Editorial Guidelines and How We Make Money.
Debt consolidation could temporarily hurt your credit in the short-term, but it has the potential to help your credit over the long-term if you use it to pay off your debts. Debt consolidation may be an option for you to consider if you have high interest rates or multiple payments that are tough for you to juggle.If you’re wondering, does debt consolidation affect your credit?, read on to learn how debt consolidation works and the pros and cons of the process.

Debt Consolidation

Debt consolidation is when you take multiple loans and credit card balances and refinance them into one new loan with a new lender. Once you receive the funds from the new lender you pay off your debt and then begin making payments on the new loan.There are a number of ways to consolidate your debt, such as balance transfer cards, personal loans, home equity loans, and home equity lines of credit. Consolidating debt can save you money if you get a new loan with a lower interest rate. It can also streamline and simplify your payments. 

Importance of a Credit Score

Your credit score is a key indicator of your creditworthiness, or how likely you are to pay your bills on time. Your credit score can help determine whether you’ll get approved for a loan, credit cards, or a mortgage. Your credit score can also impact the interest rate you qualify for, which means that you could potentially receive a higher interest rate if you have a bad credit score

Factors That Affect Your Credit Score

Your credit score is determined by several factors, including:
  • Payment history: whether your payments are on time, late, or missed
  • Credit utilization: the amount of credit you’re using divided by the amount available to you
  • Length of credit history: the ages of your credit accounts
  • Mix of credit types: the different kinds of credit accounts you have
  • Recent applications: the number of recent requests for credit you’ve made

Determining the Amount of Debt to Consolidate

When deciding how much debt to consolidate, start by making a list of your current loans and credit cards. For each, include the total balance, interest rate, minimum monthly payment, and total remaining payments. Loans and credit cards that have low interest rates or small balances may not be ones that you want to consolidate. On the other hand, if you have a lot of different sources of debt that have high interest rates, you might want to consider consolidating those.Next, decide what kind of debt consolidation option you’re interested in, and get quotes from multiple lenders. Be sure to compare interest rates and terms. If you find a new loan or credit card that you like, be sure to apply within two weeks to avoid multiple hard inquiries on your credit report, which can negatively affect your credit score. Recommended: Guide to Payday Loan Consolidation

Debt Consolidation’s Affect on Your Credit

So how does debt consolidation affect your credit? Consolidating debt may have both positive and negative effects on your credit score. Here’s why.When consolidating debt, there are a few things that can cause your credit score to drop in the short-term. Applying for a personal loan or a new balance transfer credit card will likely trigger a hard inquiry on your credit, which may lower your credit score temporarily by a few points. If you are approved for a personal loan or a balance transfer card, your score might also take a hit when you open the new credit account. Opening a new account also lowers the average age of your accounts. Having older credit accounts with a history of on-time payments generally has a positive effect on your credit score. When you add a new account, this may temporarily lower your account age and credit score.However, consolidating debt might also have positive effects on your credit score. Debt consolidation could lower your credit utilization ratio because the amount of your available credit will increase. Also, if you make the payments on your new loan on time, your credit score may increase over time. Payment history is one of the biggest factors in your credit score. 

Personal Loans

A personal loan is a type of loan that can be used for a variety of purposes, like home renovations, paying for a medical procedure, or consolidating debt. With a personal loan, you get a lump sum that you pay back in regular monthly installments over time. If you are thinking about using a personal loan as a loan to consolidate your debt, compare the interest rate of the personal loan with the interest rate of your existing debt. Credit card interest rates are typically higher than the interest rates on personal loans. You can explore personal loan rates to find an option that might work for you. You can also spend some time comparing debt consolidation and personal loans to see which one might be a better fit for your situation.Recommended: Guide to Debt Consolidation Loans for Veterans

Credit Cards

Balance transfer credit cards offer introductory periods with no interest on balances transferred over from other credit cards. During the introductory period, you could work on paying off existing debt without accruing additional interest. Most credit cards charge a balance transfer fee, but it could still be worth the cost if you would be saving money overall. 

Debt Consolidation vs Debt Settlement Impact on Credit

Debt consolidation means that you combine debts into one new loan, ideally with more favorable terms. With debt settlement, you renegotiate your debt with creditors — either on your own or using a for-profit company to do it for you — and get the creditors to agree to settle for less than what you owe. When you enroll in a debt settlement program with a for-profit company you typically stop paying your bills and instead deposit money in an account set up by the settlement company. Once there are enough funds in the account, thye company pays your creditors after negotiating a sum that’s less than what you owe. The process can take several years.Both processes may have positive and negative impacts on your credit score.
Debt ConsolidationPositive Impacts on CreditNegative Impacts on Credit
You may be able to pay off debt faster, which could help your creditYou may have extra fees when consolidating debt
Debt consolidation may come with lower interest ratesDoesn’t help you address your overall financial problems 
Debt payment is streamlined, so you may be less likely to miss or be late with paymentsThere could be an initial dip in your credit score when opening a new credit card or taking out a new loan for debt consolidation
Debt SettlementPositive Impacts on CreditNegative Impacts on Credit
You might be able to avoid having to file for bankruptcyMost debt settlement programs require you to stop making payments, so your accounts might become past due
You may be able to reduce your overall debtPenalties, late fees, and interest on your debts will continue to accrue
You may be able to pay off your debt soonerDebt settlement fees can be high
If you drop out of debt settlement, your credit score will suffer
Even if you had no late payments, settled accounts stay on your credit report for seven years

Alternative Debt Consolidation Options

There are other methods of debt consolidation you may want to consider. However, these options can affect your credit score as well. For instance, you could get a home equity loan, which allows you to use the equity in your home as collateral to borrow money. You will typically need at least 15% equity in your home to qualify. Generally, it will entail a credit inquiry on your credit report. Also, if you default on a home equity loan, you could lose your house.Another option is a home equity line of credit, which allows you to borrow against your home’s equity up to an approved limit. Instead of receiving a lump sum, you can borrow funds as needed. A HELOC will also involve a hard credit inquiry, which can affect your credit. And if you can’t pay off what you owe, the lender could foreclose on your house.You could also look into a debt management plan. These plans are typically offered by a nonprofit credit counseling agency. Instead of making payments to your lenders directly, you make one monthly payment to the agency, which will then pay your lender. A debt management plan generally doesn’t directly affect your credit score, but it will be noted on your credit report while it is in effect. After the plan is completed, it will be removed from your credit report.

Personal Loans With Lantern

A personal loan could be a way to consolidate your debt. If you’re interested in exploring personal loans, Lantern by SoFi can help. By filling out one simple application, you can get offers from multiple lenders in our marketplace. The process is quick and convenient.Explore personal loan options with Lantern.

Frequently Asked Questions

Does debt consolidation affect your credit?
How much debt can you consolidate?
Does debt consolidation or debt settlement affect your credit more?

About the Author

Jason Steele

Jason Steele

Jason Steele has been writing about credit cards and award travel since 2008. One of the nation's leading experts in this field, he has contributed to dozens of personal finance and travel outlets and has been widely quoted in the mainstream media.
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