How Does Debt Consolidation Affect Your Credit Score?

Quick Answer

Consolidating your debt can impact your credit score, but as long as you manage your debt responsibly, any negative effects will be temporary. Understanding your options and how they affect your credit score can help you determine the right steps.

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Debt consolidation has the potential to help or hurt your credit score—depending on which method you use and how diligent you are with your repayment plan. But there are ways to lessen the negative impact on your credit score and use consolidation to build your credit score over time.

How Debt Consolidation Affects Your Credit Score

Debt consolidation entails taking out one loan to pay off others, often through a personal loan or a balance transfer credit card. Depending on how you choose to consolidate your debt, there are a few different ways it can impact your credit score.

When Debt Consolidation May Lower Your Credit Score

Here are three ways consolidating your debt can potentially hurt your credit score, even if only temporarily:

  • The addition of a new account: If you're opening a new account to consolidate your debt, such as a balance transfer credit card or a personal loan, the new account will lower the average age of all of your accounts, which can negatively impact the length of your credit history. That average will increase over time, though, especially if you avoid taking out new credit accounts unless you absolutely need them.
  • Higher credit utilization: If you're planning to use a balance transfer card to consolidate credit card debt, you could run into problems if the new card has a lower credit limit than the original one. The higher the percentage of your credit limit that you're using at a given time, the worse it is for your credit score. This can also impact you if you choose to get on a debt management plan recommended by a credit counseling agency and the credit counselor requires you to close your credit card accounts. However, as you pay down your balances, your credit utilization rate will return to a lower level.
  • Credit inquiry: Anytime you apply for credit, a creditor requests to look at your credit file, which comes up as a hard inquiry on your credit report. Hard inquiries can temporarily knock a few points off your credit score; however, they're only considered for 12 months by FICO, and they typically don't harm your credit score by much.

When Debt Consolidation May Raise Your Credit Score

While debt consolidation can potentially hurt your credit score temporarily, you can also use it to build credit over time. Here are a couple of situations where it can help raise your credit score:

  • Lower credit utilization: If you transfer your credit card debt to a balance transfer card with a higher credit limit, the resulting lower utilization rate can help improve your credit score. The same goes if you use a loan to pay off credit card debt, bringing your utilization rate down to zero on that card.
  • On-time payments: As you work to make all of your payments on time, the positive payment history will help improve your credit score over time. Remember, your payment history is the most important factor in your FICO® Score , so paying on time should be a top priority.

Consolidating your debt can also help you improve your financial situation as a whole, which can make it easier to stay on top of your other debt payments.

How to Consolidate Debt

Depending on your situation, there are a few different ways you can consolidate your debt. Here's a quick summary of each:

  • Balance transfer: You can transfer existing credit card balances to a balance transfer credit card card that charges low or no interest for a certain period of time. Some card issuers offer upwards of 18 months with no interest, but they do generally charge a balance transfer fee, which can be up to 5% of the transfer amount. You typically need good credit to get approved.
  • Personal loan: Called a debt consolidation loan when it's used for that purpose, a personal loan can be a good way to consolidate credit card debt because it gives you a structured repayment plan. The current average interest rate on a two-year personal loan is 9.09%, according to the Federal Reserve, but your rate will depend on your creditworthiness.
  • Home equity loan or home equity line of credit (HELOC): If you own a house, you may be able to tap some of the equity you have in it to pay down your credit card debt. Home equity loans and HELOCs can offer low interest rates, but closing costs can be high. This option may be available even if you have less-than-stellar credit. But keep in mind that because they use your home equity as collateral, you can lose your home if you default on payments.
  • Debt management plan: If your credit is in poor shape and other debt consolidation options aren't available to you, you may consider a debt management plan. You'll get this through a nonprofit credit counseling agency, which may negotiate a lower interest rate and monthly payment with one or more of your credit card companies. You'll typically need to close your credit card accounts and pay modest upfront and ongoing fees.

Best Practices for Debt Consolidation

Consolidating your debt can be a daunting task, but with the right strategy, it can become a little less intimidating. Here are some best practices to help guide you through the process.

1. Add Up All Your Debt

Tally up the balances on the accounts that you want to pay off, as well as their interest rates and monthly payments. This will give you an idea of what you're working with. You may also want to compare the payments to your budget to see if you can afford to pay more than what you are currently paying.

2. Shop Around for Offers

Regardless of which type of consolidation you want to pursue, take some time to research and compare offers from several sources. This can help you narrow down the list of options to the ones that will best help you achieve your goals.

If you have great credit, you'll be able to consider more than one approach to consolidating your debt, including balance transfer credit cards, personal loans and home equity products.

3. Stick to a Repayment Plan

Once you've completed the consolidation process, stick to the plan you made. For example, if you got a balance transfer credit card with the intent to pay down the balance before the introductory 0% APR period ends, make it a priority to stick to that goal. Otherwise, you'll be assessed interest at the issuer's standard rate on the remaining balance.

Sticking to your repayment plan is most important if you're on a debt management plan. If you can't keep up, your plan may be terminated, forcing you to deal with the debt on your own.

4. Avoid More Debt

Even if you don't have to close your credit card accounts, avoid adding new debt to the cards while you're working to pay down your balance. Otherwise, it can feel like you're taking two steps forward and one step back. Additionally, it's a good idea to take steps to address the issues that caused the debt in the first place.

Debt Consolidation Alternatives

Debt consolidation can help you get to where you need to be financially to pay off your debt. It may cause you to experience some negative effects on your credit score in the short term, but the upside of becoming debt-free may be enough to outweigh the costs.

But if the debt consolidation methods listed above are unappealing or unattainable, there are alternatives you can explore.

  • Stick to a budget. Creating a budget and sticking to it could be your ticket to getting out of debt. Take a look at your financial statements for the past few months and categorize each expense to get an idea of where your money goes. Then look for areas where you can cut back on your spending and allocate that money toward debt payments instead.
  • Use the debt avalanche method. The debt avalanche method is an approach to paying off debt that can accelerate your debt payoff and save you money along the way. With this strategy, you make just the minimum payment on all of your debts except for the one with the highest interest rate, to which you'll pay as much as you can. Once that debt is paid off, take all the payments you were making toward it and apply them to the account with the next-highest interest rate until it's paid off. Repeat this process until all of your debts are paid in full.
  • Use the debt snowball method. The debt snowball method is similar to the debt avalanche method except instead of targeting your highest-interest debt first, you'll focus on the accounts with the lowest balances. While the debt avalanche method may help you save money on interest, the debt snowball method can help you stay motivated because you'll see wins early in the process as you eliminate smaller balances.

Monitor Your Credit as You Pay Down Debt

Whether you choose to consolidate your debt or pay it off another way, it's important to keep an eye on your credit score and track how your actions impact it.

Experian's free credit monitoring service offers access to your FICO® Score and Experian credit report, along with real-time alerts when changes are made to your credit report. This information can help you keep track of your progress and address potential issues if they arise.

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