How Does Debt Consolidation Affect Your Credit Score?

Debt consolidation could temporarily hurt your credit in the short term, but it has the potential to help it over the long term if you use it to pay down your debts. It may be an option for you to consider if you have high interest rates or multiple payments that are tough for you to juggle.

Keep reading to learn more about debt consolidation, how it could affect your credit, types of debt consolidation, and the pros and cons.

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 down 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 (HELOCs). Consolidating debt could save you money if you get a new loan with a lower interest rate. It may 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. It can help determine whether you’ll get approved for a loan, credit card, or 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 age 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, it’s a good idea to 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 many different sources of debt with high interest rates, you might want to consider consolidating those.

Next, you can 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 are shopping for a new loan or credit card, applying within two weeks allows you to avoid multiple hard inquiries on your credit report, which could negatively affect your credit score. 

Recommended: Guide to Payday Loan Consolidation

Debt Consolidation’s Effect 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 could 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 build 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, such as home renovations, medical procedure payments, or debt consolidation. 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 to consolidate your debt, it’s a good idea to compare the interest rate of the personal loan with that of your existing debt. Credit card interest rates are typically higher than those on personal loans, so if you have significant credit card debt, a personal loan could be a good option.

You could also spend some time comparing debt consolidation and personal loans to explore 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 down 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 into an account set up by the settlement company. Once there are enough funds in the account, the company pays your creditors after negotiating a sum that’s less than what you owe. The process can take two to four years.

Both processes may have positive and negative impacts on your credit score.

Alternative Debt Consolidation Options

There are other methods of debt consolidation you may want to consider. However, these options could 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, getting a home equity loan 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 HELOC, 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 could 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 nonprofit credit counseling agencies. Instead of making payments to your lenders directly, you make one monthly payment to the agency, which will then pay your lenders.

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.

The Takeaway

Debt consolidation can be a smart move if you’re juggling multiple payments or dealing with high interest rates. While you might see a small, temporary dip in your credit score from the initial application and new account, the long-term potential for a stronger credit profile is significant. Make sure you compare different options, such as personal loans or balance transfer cards, to identify the right rate for you before applying.

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 options from multiple lenders in our marketplace. The process is quick and convenient.

Explore personal loan options with Lantern.