Does debt consolidation hurt your credit?

What is debt consolidation?

Debt consolidation is the process of combining multiple debts into one. The goal is to convert several debt payments into one manageable monthly payment with a lower annual percentage rate (APR).

Consolidating your debt may help you save money over time by reducing the total amount of interest that you pay. If you're carrying high-interest credit card balances, for instance, you might be able to combine them into a single, lower-interest personal loan. This could potentially save you hundreds or even thousands of dollars in interest charges.

How debt consolidation can hurt your credit

Pursuing debt consolidation can initially knock down your credit score a bit. But don’t let this discourage you; your credit score can significantly improve in time if you make consistent payments toward your consolidated debt. Nonetheless, here are a few potential drawbacks to consider if you’re thinking about debt consolidation:

• It can decrease your average account age. Length of credit history makes up about 15% of your credit score. If you close your oldest credit account during the consolidation process, it shortens your credit history and hurts your score. Ideally, you should use debt consolidation to pay off the balances on your oldest credit cards but keep the accounts open.
• It involves a hard inquiry. Applying for a new credit product results in a hard inquiry to your credit report, which is when a lender reviews your full credit file and requires your consent to do so. Hard inquiries can temporarily lower your credit score.
• Repayment might be less flexible. If you use a personal loan to consolidate your debts, your new monthly payment will be a set amount, with no minimum payment option like credit cards offer. Having less flexibility in your monthly repayment amount may increase the risk of making a late payment, which can cause your FICO score to drop up to 180 points.

» MORE: How to check your credit score

How debt consolidation can improve your credit

Debt consolidation can positively affect the following components of your credit score:

• Payment history. Consistently making your required debt payments is critical, as payment history is 35% of your FICO score. Consolidating with a lower interest rate can give you a lower monthly payment amount that’s more realistic for you to make consistently. And keeping track of a single debt each month rather than several can also minimize your chances of missing a payment.
• Credit mix. Debt consolidation might introduce a new type of credit product — like a personal loan, credit card or line of credit — to your credit product mix. The diversity of your credit mix makes up 10% of your FICO score.
• Credit utilization. Credit utilization accounts for 30% of your credit score, making it the second-most important credit score factor after payment history. Lenders want to see that you have low credit utilization, meaning you use a low percentage of your revolving accounts’ combined credit limits. Using a loan to pay off debt from your revolving accounts — like credit cards and lines of credit — can reduce your credit utilization considerably and boost your credit score.

» MORE: What is a good credit score?

Types of debt consolidation

There are several methods of debt consolidation, each of which has different advantages and disadvantages. Here are some of the ways you can consolidate your debt:

• Personal loan: Personal loan funds are disbursed to a borrower as a lump sum, with a fixed monthly payment amount and repayment term. This helps you create a set monthly budget and gives you a clear timeline for getting out of debt. But be aware that you’ll likely pay an origination fee for a personal loan, which adds to the overall cost of debt consolidation.
• Credit card balance transfer: Some credit cards offer 0% APR for a promotional period of a year or longer. By transferring your debt to one of these cards, you effectively give yourself an interest-free grace period to aggressively pay off your debt. However, this method can come with balance transfer fees, and the balance transfer card’s APR will increase after the promotional period ends.
• Home equity loan or line of credit: If you have at least 20% equity in your home, you may be able to obtain a home equity loan or home equity line of credit (HELOC). Because the loan or line of credit is secured by your home, it will probably come with a lower APR than what you would get with unsecured debt consolidation products. That said, you run the risk of losing your home if you don’t keep up with your home equity loan or HELOC payments.
• Debt management plan: If dealing with debt consolidation independently feels overwhelming, a credit counseling agency can work with you and your creditors to create a debt management plan, which will reduce the interest rates you’re being charged and consolidate your debts into one affordable monthly payment. The agency will likely charge an initial setup fee, as well as an ongoing monthly fee that will be charged for the duration of the plan.

Additionally, there are other methods of debt consolidation that we don’t recommend, such as cash-out refinancing or borrowing against your 401(k).

If your credit score is too low to qualify for a debt consolidation product with a traditional lender, you can alternatively take out a loan from a family member or friend, or try crowdfunding. But while these approaches can save you from paying interest, they can also complicate your interpersonal relationships.

Best practices for debt consolidation

Debt consolidation can have a huge impact on your finances, but you need to follow the right steps to ensure you can get out of debt and stay out of debt for good.

Know your current credit situation

Before pursuing any consolidation options, request a free credit report and score. This will allow you not only to see what your current score is and how much you owe but will also enable you to know if there are any reporting mistakes. One study of 6,000 volunteers found that 34% of them had an error on their credit report.

If your score is low, it might be better to work on improving your score before applying for a new consolidation loan or credit card balance.

Budget for successful debt repayment

It is important to know how much realistically you can spend on debt repayment each month. Remember, the more you pay toward your debt load, the faster the repayment process will go. Your debt repayment process doesn’t have to feel like total deprivation, but it is best to cut back on a few unnecessary luxuries, such as streaming services, subscription boxes and eating out, for a few months. Knowing how much you need to spend on essentials, including housing and groceries, will help you see which areas can be trimmed and dedicated towards debt repayment.

Stop adding to the debt load

If you want to see concrete progress in your debt repayment, you need to stop adding to your debt load. For example, if you consolidate several credit cards into one repayment option, stop using those cards. Keep the card accounts open to reduce your credit utilization, but unlink the cards from your online shopping accounts or digital wallet so that you aren’t tempted to use them in a pinch.

Know when to get professional help

If at any point your debt repayment journey feels overwhelming, seek help with a credit counseling company. Many companies offer free counseling webinars and resources. If you do enroll in a debt management plan, monthly fees should be manageable since it is regulated by your state.

Bottom line

Carrying large amounts of debt can be stressful. Thankfully, there are several ways you can consolidate your debt and improve your credit, including taking out a debt consolidation loan. But be mindful of the impact that different debt consolidation methods might have on your credit score. Otherwise, you could wind up hurting your score more than helping it.