Does Debt Consolidation Hurt Your Credit?
Yes, consolidating your debt typically causes a dip in your credit score. But rest assured, these impacts are temporary.
How Does Consolidating Debt Hurt Your Credit?
Here are the three main ways debt consolidation can hurt your credit:
- Hard inquiries: When you apply for a loan, the creditor makes a hard inquiry. This means they pull your credit to check your creditworthiness. Every hard inquiry decreases your credit score by a few points. Some lenders allow you to prequalify online via a soft credit check, which does not impact your credit score. Also, hard inquiries only stay on your credit for two years.
- Average age of accounts: As your credit account ages and you’ve kept up with your payments, your credit score increases. Thus, opening a new account decreases the average age of your accounts, which briefly decreases your credit score.
- Credit utilization ratio: The percentage you are using of the total credit available to you (your credit utilization ratio) makes up about 30% of your FICO credit score. Although combining multiple accounts into one consolidated loan decreases the average account age, late or missed payments are even more damaging. So if consolidating your debt allows you to make your payments on time, it will increase your credit score in the long term.
The bottom line is this—though debt consolidation can hurt your credit score temporarily, if you meet your payments each month, you can improve your credit in the long run.
For more information, speak with a trusted loan officer who can offer unique financial insight based on your specific credit history.
Which Type of Loan Can Be Used for Debt Consolidation?
There are four loan options available for debt consolidation:
- Personal loan: A personal loan is money you borrow from a financial institution with a set repayment period and monthly payments. There are two types of personal loans:
- Secured personal loan: A secured loan requires you to provide collateral to the lender. Examples of collateral include a house or a car.
- Unsecured personal loan: An unsecured loan entails no collateral. Instead, lenders look at a borrower’s creditworthiness to provide a loan. Because unsecured loans are riskier than secured loans, lenders generally require higher credit scores for approval.
- Credit card balance transfer: This transfer allows you to move your loan balance to a credit card. A credit card balance transfer may be advantageous if your credit card company offers a 0% APR introductory period. This can help you pay off the balance with zero interest, though the credit card may charge a percentage of the amount you transfer, adding it to the loan principle, and if you don’t pay it off in the introductory period, the interest rate after that could be higher than the original loan’s rate.
- Home equity loan or HELOC: If you own a home, you can consolidate your debts using a home equity line of credit (HELOC) or home equity loan. This allows you to borrow money against the current value of your home. Your home’s equity is used as collateral. Home equity loans come in a lump sum, while HELOCs disburse funds as needed.
- Cash-out refinance: Another debt consolidation loan option for homeowners, a cash-out refinance allows you to convert your home equity into cash. It involves taking out a new mortgage greater than your previous mortgage balance. The difference between these two values is paid to you in cash (the amount is contingent upon the lender and your financial standing).
Eligibility for these debt consolidation options will depend on:
- The lender
- The credit card company
- Your financial standing (e.g., credit score, debt-to-credit ratio, etc.)
Speak with a trusted loan officer to help you decide which type of loan you can use for debt consolidation.
What Is Debt Consolidation?
Debt consolidation is taking out a new loan to pay off debts such as student loans, credit card debts, and other liabilities.
How Does Debt Consolidation Work?
Here’s how debt consolidation works:
- Multiple debts are combined into a single debt. Instead of making numerous payments to lenders each month, these payments would roll into one payment from a single lender.
- The consolidated loan usually comes with favorable payoff terms (e.g., lower interest rate and/or lower monthly payment).
- Payments are made on the new consolidated loan until it is paid in full.
What Are the 2 Types of Debt Consolidation Loans?
There are two types of debt consolidation loans:
- Secured: A secured loan entails providing collateral (e.g., house or car) for the loan.
- Unsecured: An unsecured loan requires no collateral. Instead, lenders rely on a borrower’s creditworthiness.
Is Debt Consolidation a Good Idea?
Debt consolidation may be a good idea if you can receive a lower interest rate and/or monthly payment. Consolidating your loans also provides you with the opportunity to organize all of your debts better and pay off your debt in a consistent manner.
Keep in mind that there may be drawbacks to debt consolidation. For example, though you might receive better rates, a consolidated loan may come with longer payment schedules. Thus, you must ensure you can commit to such timelines.
To ensure debt consolidation is the right move, we recommend speaking with a trusted loan officer to discuss your financial situation and options.
How to Consolidate Debt with Bad Credit
Though consolidating debt with bad credit can be difficult to come by, you can take steps to increase your loan approval odds.
Here’s what you can do:
- Check your credit report: Double check your credit report to ensure there aren’t mistakes that are lowering your credit score. Errors, such as wrong accounts or incorrectly reported payments, are possible and should be amended. Even a small bump in your credit score can make all the difference.
- Improve your debt-to-income ratio: Before consolidating your debt, take steps to lower your debt-to-income ratio. You can identify ways to increase your income and pay off small debts. The lower your debt-to-income ratio, the less risky you will look to lenders.
- Seek a cosigner: Some lenders will allow you to bring on a co-signer. A co-signer with a good credit score can help you qualify for a loan and get a lower interest rate. Please note that the co-signer does take on equal responsibility for your loan. If you miss payments, your cosigner’s credit score can take a hit.
- Compare interest rates and terms: It’s worth shopping around to find a lender who can meet your budget and credit score. Compare rates and get prequalified to see if there’s a good match. The pre-qualification process usually involves a soft credit check which does not hurt your credit score.
- Speak with a trusted loan officer: It’s essential to receive advice from a trusted expert to ensure you’re making the right move. Speaking with a loan officer can help you identify and consider the right financial options.