How Does Debt Consolidation Impact My Credit Score?

Debt Consolidation Loan Financial Concept

If you owe money on several credit cards, you may be struggling to keep up with your monthly payments. It can be difficult to keep track of how much you owe and to whom, and coming up with even the minimum payments can be a challenge–let alone trying to pay off the debt.

Often, when people find themselves in this situation, they may consider debt consolidation. Before making this decision, though, it is important to know what impact this could have on your credit score. Let’s look at the various ways to consolidate your debt and explain how each could impact your credit.

Debt Consolidation Loans

The most popular way to consolidate loans is to get a new loan to pay off the other debts. Depending on your credit, it can be difficult to qualify for a debt consolidation loan. One of the major factors in determining your credit score is your debt utilization. If you have maxed out, or are close to maxing out, your credit cards, this will negatively affect your credit score, which can make it difficult to qualify for a loan.

There are options available to you. Your bank or credit union may be able to help you consolidate, and online lenders, such as LendingClub.com, Prosper.com, and Avant, will also offer debt consolidation loans to borrowers with good credit. Be warned, if you do shop for a debt consolidation loan through an online lender, make sure they are reputable, as there are scammers looking to take advantage of desperate people.

How will a debt consolidation loan affect your credit? When you open a new account, your credit score could temporarily suffer, as both hard credit inquiries and new credit lines impact your score. However, the effects are generally short-term. A debt consolidation loan may help you in the long run, as it can improve your debt-to-credit ratio, and help you pay down debt faster.

Credit Card Transfer

While it is not technically a debt consolidation loan, many people decide to consolidate their debt by transferring existing debt to a lower interest credit card. If you do decide to transfer balances to a new card, though, it is imperative that you put together a plan for paying off the debt as quickly as possible. Most balance transfer offers give you an introductory rate for a limited period of time (anywhere from 6 to 21 months). If you do not pay the balance within this time period, you will have to pay interest on the entire amount you transferred, and interest rates can spike considerably, depending on your credit.

Also, be aware that most issuers charge a 3% fee for transferring the balance onto their card.

How will a balance transfer affect your credit? First of all, as with a debt consolidation loan, if you open a new credit card to consolidate your debt, you could have a temporary dip to your credit score since you will have a new inquiry and account. Having a new large installment loan on your credit report will also negatively impact your score. However, if you can find a credit card with a lower interest rate that will allow you to save money on interest and pay off your debt faster, your credit and financial standing will improve in the long run. Also, you will be lowering your debt-to-credit ratios on your other cards, which could positively impact your score.

Debt Management Plans

Technically, debt management plans are not debt consolidation programs. Rather, debt management plans are services offered through credit counseling agencies. Instead of consolidating your debt, you are actually consolidating your payments. You will send one payment a month to the counseling agency, which will then disperse your payments to each of your creditors. The benefit of a debt management plan is that the counseling agency may be able to negotiate with your creditors for a reduced interest rates and payments. Also, you can be approved for a debt management plan, regardless of your credit score.

How will a debt management plan affect your credit score? A debt management plan could lower your credit score for a variety of reasons. First of all, you will have to close all of your credit card accounts, which will negatively impact your credit score. An important factor in determining your credit score is the length of time you have had accounts open. Thus, closing accounts will lower the average age of your accounts, which will drop your score. Additionally, closing accounts can also weaken your debt-to-credit ratio. Ideally, you should use no more than 30% of your available credit. If you close all of your accounts, you will have no available credit. However, if you are having a difficult time making even your minimum payments, a debt management plan can help you get back on track and pay off your debt, which will save you money and improve your future financial situation.

Final Thoughts

No matter the temporary impact on your credit score, paying down your debt is one of the most important things you can do to improve your financial situation. Not only will you save money on interest, you may also lower your credit utilization, which will help you in the long run.

As you consider your options for debt consolidation, it is also important to take this time to examine your finances to figure out how you ended up in this situation. Make sure you are creating a realistic budget, putting money into a savings account, and setting financial goals so you do not end up in this situation again.