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Debt consolidation can help you save money and get out of debt faster, and it's possible to use the process to build your credit along the way. That said, debt consolidation can have a positive or a negative impact on your credit, depending on various factors. Here's how to take advantage of the opportunity to improve your credit score.
Ways Debt Consolidation Can Improve Your Credit Score
There are a couple different ways you can use debt consolidation to increase your credit score.
- Lowering your credit utilization: If you use a debt consolidation loan to pay off high-balance credit cards, your credit utilization rate on those credit card accounts will drop as a result. Using a balance transfer credit card is another way to consolidate your credit card debt, but you may not get the same effect. The actual impact on your credit score will depend on the differences in available credit on each card before and after the transfer.
- Making on-time payments: The most influential factor in your FICO® Score☉ is your payment history. If you make on-time payments on your new consolidation loan or credit card, that can help you increase your credit score over time.
How Debt Consolidation Could Hurt Your Score
While debt consolidation can be a great way to improve your credit health and financial standing over time, it can have a temporary negative impact on your credit at first. If you're not careful, it can also cause long-term damage in the following ways:
- Credit inquiry: When you apply for a personal loan or credit card, the lender will typically run a hard inquiry on your credit reports. According to FICO, however, each inquiry typically takes fewer than five points off your credit score, and it'll affect your score for a year.
- New credit account: When you open a new credit account, such as a loan or credit card, it reduces the average age of your credit accounts, which can temporarily hurt your credit score. Your score can recover over time, however, especially if you avoid applying for credit frequently.
- Higher credit utilization rate: Transferring your credit card debt to a new balance transfer credit card could cause your utilization rate on the new card to be higher than the utilization rates on the old cards. This elevated rate could temporarily hurt your credit score, but your credit score can eventually improve as you pay down the debt.
- Missed payments: If your debt consolidation results in a higher monthly payment that you can't afford or you miss a payment for another reason, it can cause long-lasting damage. If your payment is late by 30 days or more, that negative mark can remain on your credit reports for up to seven years.
Is Debt Consolidation a Good Idea?
The effect of debt consolidation on your credit score can be mixed, particularly in the early stages of the process. But in the right circumstances, a consolidation loan or balance transfer can have a long-term positive impact on both your credit score and your financial well-being.
In particular, debt consolidation can be worthwhile if you have good credit and can qualify for a balance transfer card or a low interest rate on a personal loan.
On the other hand, consolidation might not be the best fit for you right now if your credit needs some work and you're having trouble qualifying for better terms than what you have on your existing balances, or if consolidating debt would result in an unaffordable payment.
Alternative Ways to Improve Your Credit
If you've determined that debt consolidation isn't the right move for you, or you want to consolidate but need to increase your credit score first, here are some approaches you can take:
- Develop a debt strategy. If you have credit card debt, paying down your balances and reducing your utilization rate could be a relatively quick way to improve your credit. Consider using a strategy like the debt snowball or debt avalanche method to accelerate your debt payoff.
- Dispute inaccurate credit information. If you review your credit report and find negative information you believe could be inaccurate, you have the right to file a dispute with the credit bureaus. If the erroneous information is removed, it could potentially help improve your credit.
- Get on a debt management plan. If you're having trouble keeping up with your debt payments, a debt management plan (DMP) with a nonprofit credit counseling agency may be able to help. A DMP can negatively impact your credit score initially because credit card companies often require you to close your accounts, causing your utilization rate to spike. But a credit counselor can also negotiate lower interest rates and monthly payments, and as you pay down the debt, your credit score can rebound.
Check Your Credit Score Before Consolidating Debt
To determine whether debt consolidation is right for you, check your credit score to gauge your creditworthiness and determine your odds of getting approved for a personal loan or balance transfer card with favorable terms.
You can also use Experian CreditMatch™ to get matched with debt consolidation loans and balance transfer credit cards based on your credit profile, allowing you to compare your options side by side without a commitment.