In this article:
Debt consolidation can help simplify your financial situation, save you money on interest and even improve your credit over time. Consolidating your debt can, however, also bring with it some temporary negative effects.
Before you take a step toward debt consolidation, it's essential to understand how it might impact your credit and what you can do to ensure long-term success.
How Can Debt Consolidation Affect Your Credit?
When you use a new credit account to consolidate debt, it could impact your credit score negatively in a few different ways. Here's what can happen and how much it might affect you.
Virtually every time you apply for credit, the lender will perform a hard inquiry on your credit report. In most cases, one hard inquiry will knock just a few points off your credit score, but that effect could be more severe if you apply for multiple loans or credit cards in a short period.
Keep in mind, though, that if you're rate-shopping and applying for multiple loans, such as a cash-out mortgage refinance or student loan refinancing, your hard inquiries will typically be combined into one when calculating your credit score. This is true if all of the inquiries are within a set period, typically between 14 and 45 days depending on the scoring model.
Average Age of Accounts
Anytime you open a new credit account, it reduces the average age of all of your credit accounts. This figure is used to help determine your length of credit history—the others are how long you've been managing credit in general and when you last used credit.
According to FICO, your length of credit history makes up 15% of your credit score. But if your credit history is strong in other areas or you have many old accounts, the impact to your credit score from opening a new account may be insignificant.
Credit Utilization Rate
If you're planning to consolidate credit card debt, how you do it may impact your credit utilization ratio, which is the percentage of available credit you're using at a given time. Your total credit utilization as well as your per-card utilization play a role in your credit scores, and having too high a rate for either could work against you.
For example, let's say you have a $5,000 balance on a card with a $10,000 credit limit. Your credit utilization ratio for this card is 50%. However, if you transfer that balance to a new card with a $6,000 limit, your utilization ratio on the old card goes down to 0% and your total utilization drops to 31% (still higher than what's ideal). So what's the harm? Doing this would cause the utilization ratio on your new card to jump to an astronomical 83%.
Anytime your utilization rate—which makes up 30% of your FICO® Score☉ —increases, it could have a negative impact on your credit score. The higher your new utilization rate is, the more significant the effect will be.
That said, if you have a high utilization rate on your credit card and you use a credit card with a higher credit limit or a consolidation loan to transfer the debt, it could help improve your credit score.
If consolidating your credit card debt helps improve your ability to make payments, that could have a positive impact on your credit score over time. But bear in mind you're unlikely to see much difference if you've always made on-time payments on all your debts.
How to Consolidate Debt
There are several ways you can consolidate your debt. The right option for you depends on your current financial situation, credit history and goals.
Personal loans can be used for just about anything, including consolidating debt. Depending on the lender, you can borrow as little as a few hundred dollars to tens of thousands of dollars. Personal loans typically come with repayment terms ranging from one to seven years, which may give you plenty of time to pay off your debt.
If you have good or excellent credit, you may be able to qualify for a relatively low interest rate. But if your credit history is in poor shape, you may not be able to score an interest rate lower than what you already have.
One of the primary benefits of personal loans is that they're typically unsecured, which means you don't have to put up collateral to get approved.
Balance Transfer Credit Cards
If you're hoping to consolidate credit card debt, one of the best ways to do it is with a balance transfer credit card. Some credit card issuers may even allow you to use a balance transfer card to pay off other types of debt.
Balance transfer credit cards are appealing because they come with an introductory 0% APR promotion, which can range from just a few months to almost two years. If you can manage to pay off your balance before the end of the promotional period, you could save hundreds or even thousands of dollars on interest charges.
However, balance transfer cards typically require at least good credit to get approved. Also, many of these cards charge an upfront fee when you transfer a balance to them—an amount that typically ranges from 3% to 5% of the transfer amount. This fee can reduce your savings, so it might be worth your time to look for a card that doesn't charge a balance transfer fee.
These options save you a lot of money because they typically offer low interest rates and long repayment terms, which allows you ample time to tackle your debt without paying much in interest.
However, using your home equity to consolidate debt may come back to bite you if you're not careful. Because your home's equity is used as collateral for these loans, you may lose your house to foreclosure if you can't afford to make payments at some point in the future.
As a result, it's best to consider using your home equity for consolidation only as a last resort.
Debt Management Plan
If you're struggling financially and your credit score is relatively low, a debt management plan with a credit counselor may be a good option.
Credit counseling agencies will allow you to consolidate your unsecured debt by having you make one payment to the agency, which will then divvy it up between your creditors. The agency may also be able to negotiate lower interest rates, which could save you money. Debt management plans last three to five years.
However, it's important to keep in mind that debt management plans typically come with modest upfront and monthly fees. But they may be worth it if your only other options are debt settlement and bankruptcy.
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 to your credit score in the short term, but the upside of becoming debt-free may be enough to outweigh the costs.
If the debt consolidation methods listed above are unappealing or unattainable, however, 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.
While the process can be time-consuming, and especially so in the beginning stages, setting a budget and taking it seriously can help you reach your financial goals and pay down your debt.
The Debt Avalanche Method
The debt avalanche method is an approach to paying off debt that, if done properly, can accelerate your debt payoff and save you money along the way.
This strategy has you make just the minimum payment on all of your debts except for the one with the highest interest rate, to which you'll put 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. Because it targets your high-interest debts first, the debt avalanche method can save you more on interest charges than other payoff methods.
The Debt Snowball Method
The debt snowball method is similar to the debt avalanche method in every way except for one: Instead of targeting your highest interest debt first, you'll focus on the accounts with the lowest balances.
Whereas 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 on in the process as you eliminate smaller balances. If you're struggling to stick with your debt payoff plan, this approach may be the best option.
Make Your Credit Score a Top Priority as You Pay Down Debt
Your credit score is an important indicator of your ability to manage credit, and while you're trying to pay off debt right now, you may need to borrow again at some point in the future.
As a result, it's crucial to monitor your credit regularly and look for ways you can improve it. Also, keep an eye on your credit report to make sure you're up to speed on the information that's affecting your credit score.
As you take steps to care for your credit score, you'll be in a better position to qualify for affordable credit in the future when you need it.