Does Debt Consolidation Hurt Your Credit?

How Does Debt Consolidation Work?

Debt consolidation works by paying off your existing debts using a new loan or a balance transfer credit card. Debt consolidation can be a good strategy when you have multiple balances because it allows you to streamline your monthly payments, which can make getting out of debt more manageable. That can help you improve your financial situation as a whole.

Debt consolidation can also help you save money if you can qualify for a debt consolidation loan or balance transfer card with a lower interest rate than the average rate of the balances you want to pay off.

Learn more >> How to Consolidate Debt

How Does Debt Consolidation Affect Your Credit?

Debt consolidation may be able to help you improve your credit long term by making your payments more manageable and creating a path out of debt. On the other hand, there could also be negative effects on your credit, especially in the short term.

Ways Debt Consolidation Could Help Your Score

• Lower credit utilization: If you transfer your credit card debt to a balance transfer card with a higher credit limit, the resulting lower credit utilization rate on your cards can help improve your credit score. The same goes if you use a loan to pay off credit card debt, bringing your utilization rate down to 0% on that card.
• On-time payments: As you work to make all of your payments on time, the positive payment history will help improve your credit score over time. Remember, your payment history is the most important factor in your FICO^® Score^☉ , so paying on time should be a top priority.
• Credit mix: Your credit mix, or whether you have both installment and revolving credit accounts, has a modest impact on your credit score. Still, it shows you know how to manage both types of credit. If you currently only have credit cards, a debt consolidation loan could add to your credit mix. And, conversely, if you don't currently have any credit cards, adding a balance transfer card to the mix could have a positive impact.

Ways Debt Consolidation Could Hurt Your Score

• New credit inquiry: Anytime you apply for credit, a creditor requests to look at your credit file, which comes up as a hard inquiry on your credit report. Hard inquiries can temporarily knock a few points off your credit score; however, they're only factored into your FICO Scores for 12 months, and they typically don't harm your credit score by much.
• New account: If you're opening a new account to consolidate your debt, such as a balance transfer credit card or a personal loan, the new account will lower the average age of all of your accounts, which can negatively impact the length of your credit history. That average will increase over time, though, especially if you avoid opening new credit accounts.
• Higher credit utilization: If you use a balance transfer card to consolidate debt, you may increase your credit utilization ratio on that card. Credit utilization measures the percent of your available credit, particularly revolving credit like credit cards. The higher your utilization, the worse for your scores. But keep in mind that your credit utilization will go back down as you pay off your debt—and, if you're paying off credit cards, their utilization will decrease.

Learn more >> Is a Debt Consolidation Loan Right for You?

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Ways to Consolidate Debt

Depending on your situation, there are a few different ways you can consolidate your debt. Here's a quick summary of each:

• Balance transfer: You can transfer existing credit card balances to a balance transfer credit card card that charges a low or 0% annual percentage rate (APR) for a certain period of time. Some card issuers offer up to 21 months with no interest, but they do generally charge a balance transfer fee, which can be up to 5% of the transfer amount. You typically need good credit to get approved.
• Personal loan: Called a debt consolidation loan when it's used for that purpose, a personal loan can be a good way to consolidate credit card debt because it gives you a structured repayment plan. Before you consider this option, compare personal loans to see if you qualify for one with a rate lower than your current debts.
• Home equity loan or home equity line of credit (HELOC): If you own a house, you may be able to tap some of the equity you have in it to pay down your credit card debt. Home equity loans and HELOCs can offer low interest rates, but closing costs can be high. This option may be available even if you have less-than-stellar credit. But keep in mind that because they use your home equity as collateral, you can lose your home if you default on payments.

Learn more >> How to Get a Debt Consolidation Loan

How to Consolidate Debt

Consolidating your debt can be a daunting task, but it can become a little less intimidating with the right strategy. Here are some best practices to help guide you through the process.

1. Add Up All Your Debt

Tally up the balances on the accounts you want to pay off, as well as their interest rates and monthly payments. This will give you an idea of what you're working with. You may also want to compare the payments to your budget to see if you can afford to pay more than what you are currently paying.

2. Shop Around for Offers

Regardless of which type of consolidation you want to pursue, take some time to research and compare offers from several sources. This can help you narrow down the list of options to the ones that will best help you achieve your goals.

If you have great credit, you'll be able to consider more than one approach to consolidating your debt, including balance transfer credit cards, debt consolidation loans and home equity products.

3. Stick to a Repayment Plan

Once you've completed the consolidation process, stick to the plan you made. For example, if you got a balance transfer credit card with the intent to pay down the balance before the introductory 0% APR period ends, make it a priority to stick to that goal. Otherwise, you'll be assessed interest at the issuer's standard rate on the remaining balance.

Sticking to your repayment plan is most important if you're on a debt management plan. If you can't keep up, your plan may be terminated—and you'll have to deal with the debt on your own.

4. Avoid More Debt

While it's usually a good option to keep your existing credit card accounts open, avoid adding new debt to the cards while you're working to pay down your balance. Otherwise, it can feel like you're taking two steps forward and one step back. Additionally, it's a good idea to take steps to address the issues that caused the debt in the first place—such as overspending or the lack of a budget.

Alternatives to Debt Consolidation

While debt consolidation is a good option in many cases, it isn't a one-size-fits-all strategy. Whether your goal is to build credit or make your financial situation easier to manage, these alternatives could be worth pursuing.

• Debt payoff plan: You may be able to pay off debt on your own using the debt avalanche or debt snowball method. The debt avalanche method has you pay off your highest-interest debt first, and the avalanche method has you pay off your smallest balance first. Then, you move on to the next debt. Either method has the benefit of structuring your payoff plan to set clear priorities and stay motivated.
• Debt management plan: A debt management plan (DMP) can be a good option if you're struggling to repay unsecured debt such as credit cards, especially if you don't qualify for consolidation. You'll get a DMP through a nonprofit credit counseling agency, which may negotiate a lower interest rate and monthly payment with one or more of your credit card companies. You'll typically need to close your credit card accounts and pay modest upfront and ongoing fees.
• Debt settlement: Debt settlement is when you negotiate with your lenders to pay off your debts for less than you owe. While it may sound like a good strategy, in reality, settlement does substantial damage to your credit, can be costly and is risky—and it's possible your lenders may not be willing to settle.
• Bankruptcy: Bankruptcy is best thought of as a last resort because it does deep and long-lasting damage to your credit, and it's an expensive legal process. Chapter 7 and Chapter 13 bankruptcy each have specific requirements to qualify, and their own pros and cons. If you're considering bankruptcy as a form of debt relief, you'll need to meet with a credit counselor. They can help you evaluate your situation and discuss your options.

Learn more >> Alternatives to a Debt Consolidation Loan

Monitor Your Credit as You Pay Down Debt

Whether you choose to consolidate your debt or pay it off another way, it's important to keep an eye on your credit score and track how your actions impact it.

Experian's free credit monitoring service offers access to your FICO^® Score and Experian credit report, along with real-time alerts when changes are made to your credit report. This information can help you keep track of your progress and address potential issues if they arise.