Effects of Debt Consolidation on Credit
Debt consolidation is one of many debt relief options that can improve your financial situation. It is often mentioned in the same breath as debt management and debt settlement and in many ways serves as the middle ground between these two—not as drastic and potentially damaging as debt settlement, but a little more so than debt management.
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But how does a consolidation loan impact your credit score, what are the pros and cons, and is it the right option for you?
What is Debt Consolidation?
In simple terms, debt consolidation is the means of using one large loan to “consolidate” other loans. The idea is quite simple: If you have multiple small debts charging high-interest rates, you can acquire a large loan, pay those debts off, and then focus all your attention on that single loan.
In practice, however, it’s not quite that simple. If it was that easy to acquire a large, low-interest loan, you probably wouldn’t have all those debts to begin with. To get around this fact, a debt consolidation company simply extends the life of the loan, increasing the total interest while keeping your monthly payments to a minimum.
Is Debt Consolidation Worth it?
It can be, but it depends on what you’re looking for and why you’re looking for it. It’s also important to look at the bigger picture when consolidating your debt because it’s rarely as cut-and-dry as it might seem.
As an example, let’s imagine that you have $30,000 in unsecured debt spread across three loans, each charging 10% interest. With a loan term of 5 years, you will pay $322 for each loan per month, or $966 total. Over the full term, you’ll repay just under $35,000, or around $4,800 in interest.
If you find a company that offers to consolidate your debt, charging just 8% interest and asking for only $467 a month, it’s a no-brainer, right? A better interest rate, lower monthly payment—it’s a win-win. The problem is, to arrive at such a low monthly figure, the loan term has been extended to 7 years. Not only does this mean you’ll be burdened with the debt for years to come, but it also means you’ll be repaying nearly $40,000 throughout the term of the loan.
And this is only on the assumption that you’re actually offered a better interest rate, which isn’t always a guarantee. If we increase that interest rate to 12%, we still get a monthly payment of $529, which is sure to catch the eye of someone currently paying $966, but over the term, it generates a total repayment of $44,000.
Simply put, while debt consolidation may seem like a win-win, it can actually cost you much more than the original debt. You’re just prolonging the misery.
The strange thing is, this explanation probably hasn’t put you off acquiring a debt consolidation loan, because our brains seem to be hard-wired to focus on the short-term. Many subscription services offer huge discounts for customers who pay for 6 or 12-months all at once. But the vast majority of users will opt for the month-by-month subscription because while it’s worse value for money, the smaller figure always feels like the better option.
That’s not to say that debt consolidation is a bad thing, but rather that it’s not always the best option. If you’re struggling to meet your monthly repayments and there is a very serious risk that you’ll default as a result, it can be a great option. It’s much better than financial ruin, after all. But if you simply want some extra money in your pocket at the end of the month, it’s a terrible option.
Does Debt Consolidation Hurt Credit?
Debt relief programs differ greatly with regard to how they impact your credit score. A debt settlement company, for instance, may encourage you to miss payments so that money can be put towards settlements. In the long run, it helps to clear your debts quickly, greatly reduces the cost of credit card balances and personal loan debts, and saves you more money, but in the short-term, it can damage your credit score.
A debt management plan is much gentler on your credit score, but may also require you to cancel credit cards, thus reducing your credit utilization ratio.
So where does consolidation fit into all of this? Well, there are both positive and negative ways that it can affect your credit score:
How Does Debt Consolidation Negatively Affect Your Credit Score?
A new loan will always show on your credit report and will reduce your score in a number of ways. As discussed in our guide to How Your Credit Score is Calculated, everything from payment history to credit utilization, age, and inquiries are factored into the equation. With a new loan, you’re initiating a hard inquiry, which could reduce your score by as many as 5 points, but you’re also opening a new account and reducing the average age of existing accounts.
The way this impacts your score will depend on your current financial health, but it’s enough to drop you out of the “Very Good” range and into the “Good” one.
Your credit utilization ratio may be affected as well. This accounts for 30% of your total score and compares all available debt to all available credit. You can negate this issue by keeping cleared credit cards active.
Debt consolidation by way of a balance transfer can also come with its own unique problems. Not only will your score take a hit when you open the account, but if you spend a lot of time searching for preferable rates, you may acquire multiple hard inquiries, each knocking up to 5 points off your score.
Credit scoring agencies do allow for something known as rate shopping, where you can apply for multiple loans or lines of credit in a fixed period (14 to 45 days depending on the scoring model) and providing they are the same type (personal loan, auto loan, etc.,) they will all merge into one. However, this does not apply to balance transfer cards or other types of credit card.
Last but not least, if you fail to make the monthly payments on your account then your payment history will be affected, which accounts for the highest percentage of your score.
How Does Debt Consolidation Positively Affect Your Credit Score?
As mentioned above, your payment history exerts the greatest influence on your credit score. It can drop drastically following a single mistake or oversight, but it takes a while to improve and requires you to keep making those payments. Debt consolidation provides more of a guarantee that this will happen, as it makes your debts more manageable and ensures that you’ll meet payments even during difficult periods.
It can also clear existing balances and turn multiple debts into one. This won’t improve your utilization score directly, but it will clear some of those accounts and improve your credit history.
If you use a consolidation loan to clear multiple credit card debts, you will also benefit from the component of your score that looks at different types of credit. Lenders want to know that you’re capable of managing different debts and that you’re not fixated on loans or credit cards, so this component is given a surprising amount of weight when calculating your score.
Pros of a Debt Consolidation Loan
Debt consolidation has its advantages and it may be preferable to more “extreme” options like debt settlement. If a debt settlement company requests that you stop making payments, for example, it could result in lawsuits and credit score damage. Debt consolidation can feel like a gentler and simpler process, offering benefits such as:
Lower Monthly Payment
A debt consolidation loan is designed to reduce your monthly payment. It’s not uncommon to see your total monthly payment drop by more than half, which can feel like a huge weight off your shoulders if you’ve been struggling to meet those obligations every month.
Can Help with All Debts
Some debt relief services are very specialized. Debt settlement, for instance, tends to work best with credit card debt, as it’s an unsecured debt that’s often sold cheaply to collection agencies and these tend to be willing to settle. Consolidation, however, works with all forms.
There are specific services available to consolidate different types of debt, including credit card debt, personal loan debt, and student loans.
Only One Debt
You can’t underestimate the benefit of turning multiple debts into one. You feel more in control and less stressed. If you’re prone to forgetting things or your finances dip into the red every month, this can be incredibly valuable.
You no longer have to worry about all those repayments and the potential fines that accrue when you’re late. If you have a few bad months and can’t meet payments, it will only show on one account and won’t impact your credit score as severely.
More Money in Your Pocket
Last but not least, your monthly payments are lower, which means you’ll have more money in your pocket every month. That shouldn’t be an invitation to spend frivolously, however. Try to use the money to clear other debts, if you have them; clear more of the debt’s principal if you can afford to, or put it aside for a rainy day.
Cons of a Debt Consolidation Loan
There are more pros than there are cons, and we might be nit-picking a little here, but some of these disadvantages are huge and need to be considered carefully before you think about consolidating your debt.
You’ll Pay Much More Over the Term
We have discussed some of the ways that consolidation is preferable to a debt settlement program, but there is one area in which debt settlement is superior: You’ll always pay less than the value of the loan.
A consolidation loan works by prolonging your loan term, which increases the total amount that you pay. Depending on your credit score and credit history, you may be offered a term that results in you paying twice or three times the amount of interest that you would have paid on the original debts.
You might not feel it as much, on account of the lower monthly payment, but your finances will take a bigger hit in the long-term.
False Sense of Security
A consolidation loan can give you a false sense of security. Your credit card debt has vanished, those personal loans have cleared, and you only have one debt to focus on. You’re only paying a couple of hundred bucks a month and have a lot more expendable income than you did.
In this situation, it’s very easy to get carried away, to think that you’re doing better than you are. You spend more than you can afford; acquire more debt than you can repay. Before you know it, your credit card balances are sky-high again, your credit score is rock-bottom, and you’re in dire need of more consolidation.
Doesn’t Change Spending Habits
A debt management program often proceeds credit counseling, helping the debtor to understand how they got into that position and to prevent it from happening again. Sacrifices are made, belts are tightened, and the risk of additional debts and problems decreases significantly.
But it’s a different story with debt consolidation. At best you’ll be offered some online resources and maybe a short credit counseling session where the main goal is to sell you on their program. There are no major sacrifices and when all those turns turn into one manageable debt, it’s very easy to slip back into those habits.
If a consolidation loan is the only loan you have, it’s manageable and shouldn’t impact your credit score too much. But if you have credit card debt and personal loan debt as well, you could find yourself with a rapidly diminishing debt-to-income ratio and very few options.
What About Balance Transfer Consolidation?
As alluded to above, the biggest issue with consolidation is that it greatly increases the term of your loan and the total interest you repay. But there is another way: Balance transfer consolidation.
This is something you can do yourself without the help of a specialist company seeking to earn their pound of flesh. Just look for a balance transfer credit card that offers a 0% introductory rate, something that most of these cards provide to new users. It will typically offer this rate for at least 12 months, after which a high-interest period will commence.
Once the card is active, simply move existing credit card debt across and then use that introductory period to gradually clear your debt without paying exorbitant interest. There will be fees involved, usually expressed as a percentage of the balance transfer total, and your score will also take an initial hit with the new account and the inquiries that precede it, but if you’re looking for a low-cost, fast, and interest-free way to consolidate, it’s ideal.
Are There Any Other Types of Debt Consolidation?
Debt management is technically a type of consolidation, but it’s something we have treated separately as the process is different and it can also have more of an impact on your credit score. See our guide to Debt Management Plans to learn more about this process and to discover if it’s right for you.
It’s possible to consolidate your debt via a home equity loan or a 401(k). In the first instance, you’re leveraging collateral to acquire money you can use to clear your debts, after which you can focus on meeting those home equity payments. The problem is that you’re essentially turning unsecured debt into secured debt, adding an asset where none is required.
If you fail to meet payments on a debt consolidation loan, there are still settlement options and outcomes that don’t involve risking your assets. But if you fail to make home equity loan payments then you could lose your house, which will be especially heartbreaking if you’ve spent years paying off the mortgage and were close to owning it outright.
As for a 401(k), you can cash a large sum from your retirement fund with a low-interest rate and no credit check, with repayments simply being deducted from your wages. But removing cash from your retirement account will greatly reduce its earning potential because those earnings are based on compounded interest. You may also face penalties if the amount is not repaid in full.
These options are viable. In some circumstances, they may be all you have. But we wouldn’t recommend them unless they really are a last resort and all other possibilities have been exhausted.
When is a Debt Consolidation Loan Appropriate?
If you’re struggling to manage your outgoings and have multiple high-interest debts, a consolidation loan may be the best option. If you have a single high-interest credit card balance, you may want to consider a balance transfer, which can provide many of the same benefits.
The problem with debt consolidation is that those who need it the most are often turned away. It’s something you only apply for when your credit is suffering and your debt to income ratio is high, but because of this, a loan company may refuse you. Or worse, they may give you a high-interest loan that you feel you have to accept, despite the fact you’ll pay extortionate amounts of interest.
Every time you’re met with a brick-wall of refusals and unappealing offers, it’s time to reevaluate and consider one of the other forms of debt relief instead. You can find extensive articles on all these subjects right here on this site, but here is a brief rundown:
The debt management process is actually quite similar to the consolidation one, but with a few notable differences. This service is provided by nonprofits and is offered to debtors who are struggling to meet their obligations and/or have more debts than they can afford.
The company will negotiate with your creditors to create a repayment plan that you can afford, and then request that you make a few sacrifices, including canceling all but one credit card and only using it in emergencies. All payments are made to the debt management company and then distributed accordingly.
A debt settlement company works with your credits to negotiate your debts, after which you pay a lump-sum to clear them. They only charge when they have completed the settlement process and their fee is a percentage of the debt or settlement amount.
There are some scams in the debt settlement industry and the process may also damage your credit score in the short term, potentially leading to collections, harassing calls from creditors/collectors, and even legal action. However, it all usually works out in the end. In terms of money saved, debt settlement is one of the most effective solutions for debt relief.
If you’re worried about debt collectors, take a look at the Fair Debt Collectors Practices Act (FDCPA) which protects your rights when dealing with debt collectors and limits their authority. It’s important to be aware of this as many collectors flout these laws and are very deceptive in their practice.
Bankruptcy is not something you should take lightly. It’s a decision that could stay with you for years, with some claims remaining on your credit report for up to 10 years from the date of filing.
There are two types of personal bankruptcy: Chapter 7 and Chapter 13. Each differs with regards to exempt assets and processes, but Chapter 7 is generally aimed at individuals who lack the means to meet their financial obligations, while Chapter 13 is more of a reorganization process.
Conclusion: It All Works Out in the End
Debt consolidation doesn’t have that much of an impact on your credit score, at least not directly. There are many potential pitfalls with this debt relief method, but these vary from person to person and the way it impacts credit score is immaterial. Whatever damage it does in the short-term will be rectified in the long term, providing you keep making those payments.
It should not be seen as an easy way to free-up additional cash, but rather as a way of reducing your default risk, making unmanageable debts manageable, and helping you to get back on track. If that’s genuinely how you see debt consolidation, then it could be the right option for you; if not, then you might want to reconsider.