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Does Debt Consolidation Affect My Credit Score

How Does Debt Consolidation Affect My Credit Score?

Last updated: January 09,2023
Originally Published: July 09,2020
by Rosen Valchev

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How to take advantage of debt consolidation

Does debt consolidation affect my credit score positively or negatively? The short answer is – It depends. You should determine whether loan consolidation makes sense depending on your specific financial situation.

To give you the best idea on how to take advantage of debt consolidation let’s first discuss a few crucial matters. When should you opt for debt consolidation? How can you perform a debt consolidation? Last but not least, is debt consolidation going to hurt your credit score or it can actually help you increase it?

When to perform debt consolidation?

Generally speaking, you should consider consolidating your debt if it’s going to help you alleviate your financial struggles. Here are the two top reasons to perform a loan consolidation.

1. If you can’t keep track of all your loans

Many people find it difficult to juggle multiple loans or credit cards. When you have credit with several lenders it can be extremely frustrating to track all payment amounts and due dates.

Often, you can fail to meet deadlines and incur late fees. This also hurts your credit score. So if you find yourself in a similar situation you should take immediate action.

Debt consolidation can be a perfect solution in this case. You can get a single loan from a single lender, typically with a fixed monthly payment, and use it to cover all other outstanding loans you have. This can certainly make your life easier. You have to track only one monthly payment and due date.

The best part is your credit score will increase in the long haul. When you are making timely payments for the right amount, your behavior improves in the eyes of credit bureaus.

2. If you can get a better interest rate and lower the overall debt amount

When you have multiple loans they typically come with different interest rates and annual fees. If you can get a better interest rate on a new loan you might consider consolidating your debt. Why pay more when you can pay (and stress) less? 

However, you shouldn’t consider the interest rate alone. The repayment period is an equally important part of the equation. To give an oversimplified example, let’s imagine you currently owe $10,000 which should be repaid in 3 years with a 15% fixed APR charged on the principal. That makes a total of $14,500 you should pay for the whole period.

Now, imagine you take out a debt consolidation loan for the same amount with 10% APR and 5 years repayment period. At first, it may seem like a bargain. But the total you will pay is 15,000 which is more than the amount you owe originally. 

Of course, your monthly installments will be lower which is an advantage. So it is up to you to decide.
In most cases, credit cards have very high APRs. That is the reason many people consider consolidating their credit card debt with another loan.

It is a great option but there is an alternative to that. You can combine all your current credit card debt into a new credit card with a balance transfer.

If the new credit card has a lower interest rate that is great. However, the best option is to get cards that offer 0% intro APR because these cards provide cardholders a specific time frame where they don’t have to pay for interest (usually between 12-24 months)

There are many lenders that waive the interest for a certain period of time as a credit card sign-up bonus.  You can check the best three 0% interest rate credit card offers for 2020 and see for yourself.

credit card high APR debt consolidation Debt Consolidation Affect My Credit Score
Image by TheDigitalWay from Pixabay

Choosing the right type of debt consolidation loan

There are different ways you can do debt consolidation. All of them have one thing in common. You get a single, new loan to cover all or most of your existing loans. Let’s take a look at the loan options you have to perform debt consolidation.

Personal Loan

Most individuals prefer this approach. Getting a personal loan with a lower interest rate to cover your credit card debt is often a great idea.

Nevertheless, make sure you don’t end up paying more than you should. Usually, personal loans have origination fees and high annual fees. That can eat up the difference in the interest rate you will save.

On the bright side, you will have only one payment to worry about. Banks offer personal loans and that is the first place most people go to seek one.

While banks can provide good rates they usually demand a great credit score and perform a hard credit check that can hurt your credit score even if you are not approved. That is why online lenders are a great alternative.

For example, with guidetolenders you can compare multiple lenders and choose the best one for your debt consolidation loan. The process is extremely smooth (as opposed to banks). You can get approved easily and your credit score remains untouched when you compare lenders.

Also, you can get your funds in 24 hours from approval which can’t happen with most regular bank providers.

Another important factor to consider before taking out your personal debt consolidation loan is the amount you qualify for. You want to make sure the amount will be sufficient to cover all outstanding debt you have.

Also if you have excess cash you can use that to your advantage to pay of your loan faster and cheaper once you perform debt consolidation. To make that work you should take out a personal loan that has no prepayment penalty

Balance Transfer Cards

We already mentioned you can use balance transfer cards to consolidate your debt. If you choose that option, makes sure you don’t get in the trap of overspending.

When you clear your credit card balance it is tempting to go back to your old spending habits. You should be cautious about that and act smart. If you play your cards right you can even increase your credit score.

Read More: How to Increase Credit Score to 800

Home Equity Loan

Unlike personal loans and balance transfers, this is a secured loan. If you stacked up ownership in your home you can use that as collateral to get a lump sum and cover your debt.

However, be very mindful. If you can’t repay the loan you can lose your house. So don’t take an unnecessary risk if you are not 100% sure you can keep up with the payments.

Borrow money from your 401(k) plan

This is not a typical approach but you can also borrow money from your retirement savings with a 401(k) loan. Usually, taking out a 401(k) loan isn’t the greatest idea.

That’s because it can affect negatively the return rates of your pension plan especially if you choose a bad moment to draw it. Moreover, paying interest to borrow your own money just doesn’t sound right.

Debt Settlement

In their effort to save money many people resort to debt settlement companies. These companies offer to settle your debt at a much lower rate than your original debt amount.

Many individuals think this is a good approach to lower their debt amount. Unfortunately, that is not true.

Ultimately you can hurt your credit score severely and risk being sued by the lender. That is why debt management is a much better alternative to debt settlement.

Does debt consolidation hurt your credit score?

Debt consolidation can affect your credit score both positively and negatively, depending on your behavior. When applying for a personal loan or a balance transfer card your credit score will slightly drop in the short term.

That is happening mainly for two reasons:

  • Lenders perform a hard credit inquiry to issue a balance transfer card or a personal loan.
  • You are closing old credit accounts that have history and simultaneously opening a new one. Credit institutions consider new credit accounts as riskier and that is why they lower your credit score.

However, in the long run, by improving your repayment behavior your credit score will bounce back and even increase. If you are paying your installment in full and you consistently do it on time, you are on the right track. 

Ensure you don’t return to old spending habits. Your credit cards’ cleared balances may trick you into spending more but don’t do that. Remember why you consolidated your debt in the first place.

On the opposite side, if you have a flawless credit history you should think carefully before consolidating your debt.

There is a high chance your credit score will drop significantly and remain there for a certain period of time.

Debt Consolidation Pros

  • Increases credit score over time
  • It can lower your interest rate
  • You can pay less than your original debt amount
  • You have only one payment and due date to worry about

Debt Conolidation Cons

  • Your credit score drops by a few points initially
  • After consolidating your debt, you may continue bad spending habits and end up in more debt

Consolidating your debt is in your hands

Now you know everything you need to decide whether debt consolidation would make sense for you. Don’t let doubt and fear distract you from handling your debt. Many lenders are currently more flexible because of the Coronavirus so now may be the best time to take action.

The first step is to check your options. You can head to guidetolenders or use another similar platform, like smarter loans, for example. The choice is yours. Your debt-free future is in your hands.

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