Debt consolidation can drastically improve your financial situation. However, since it involves your credit, you might be wondering whether it’s possible to consolidate your debts without hurting your credit score.
The truth is that debt consolidation can affect your credit score in different ways. It has the potential to either harm or help it, depending on the method you choose and what your credit history looks like.
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How does debt consolidation affect your credit score?
Consolidating your debts may cause a temporary drop in your credit score, but it also offers the opportunity to improve your credit score in the long term. We’ll explain both below.
How debt consolidation can hurt your credit score
Debt consolidation often involves applying for new credit, such as a loan or credit card, which you’ll immediately use to pay off all of your other debts. This can damage your credit in two ways.
1. You may trigger a hard inquiry
Most credit applications involve a credit check, which triggers a hard inquiry. These hard inquiries lower your credit score. Fortunately, the effect is temporary—hard inquiries can stay on your credit report for two years, but their impact on your credit lasts no more than a year. 1
2. It will lower the average age of your accounts
Opening a new credit account automatically affects the length of your credit history (which accounts for 15% of your FICO score) by reducing the average age of your accounts. This will lower your score.
How big the impact is and how long it lasts depends on how many credit accounts you currently have and how old they are. As with hard inquiries, the drop in your score will be temporary; as the new account ages, the negative effect will diminish.
How debt consolidation can improve your credit score
Despite the potential negative effects that debt consolidation can have on your credit, it can also improve your credit score in three ways.
1. It protects your payment history
If you’re at risk of missing a credit card or loan payment, then debt consolidation can protect your credit from the damage that comes from late payments.
Consolidating your debts makes it easier to manage your bills because you’ll only have one payment due date. Ideally, you’ll also have a lower monthly bill because your new loan or credit card will have a lower interest rate than you were previously paying.
2. It will lower your credit utilization rate
Your credit utilization rate is the amount of credit you’re using compared to your credit limit on your credit cards. It’s one of the most important factors contributing to your credit score.
Consolidating your debts can lower your credit utilization ratio in the following ways:
- Increasing your overall credit limit: If you get a new credit card to consolidate your debts, then the new account will automatically increase the total amount of credit available to you.
- Lowering your credit card balances: On the other hand, if you get a loan instead of a new credit card, moving all your debt from your cards to the loan will reduce your credit utilization ratio to 0%. (Note that this only works if you keep the accounts open after transferring your debt.)
- Reducing the number of accounts with a balance: Transferring debt from several credit cards to a loan or credit card can benefit your score by reducing the number of accounts you have with a balance, which some credit scoring models will reward. 2
3. Credit mix
If you currently only have credit cards (aka revolving credit accounts), then taking out a loan to consolidate your debt will benefit your credit scores by improving your credit mix—the diversity of your credit accounts.
Although credit mix accounts for a relatively small percentage of your credit score (10% in FICO’s models), diversifying the types of credit you have can give your score a small boost and make you more attractive to lenders.
Ways to consolidate your debts (and how they affect your credit)
There are three common approaches to debt consolidation:
- Debt consolidation loan: This is a type of installment loan, i.e., a lump sum that you receive at once and pay back according to a fixed schedule. You can get one from a bank, credit union, or online lender.
- Home equity loan: This is a type of secured loan that uses your home as collateral, similar to a mortgage. You borrow against the equity you have in your home (the value of your home minus what you still have left to pay on your mortgage). These loans tend to have lower interest rates than credit cards and personal loans, but they’re much riskier because you could lose your home if you fail to repay the debt.
- Credit card balance transfer: With this approach, you transfer the balances from multiple credit cards to a single card (ideally one with a lower interest rate). You can use a card you already have or get a new balance transfer credit card, some of which come with introductory 0% APR periods.
In general, the first two options will usually be slightly better for your credit score than transferring your debts onto another credit card.
Credit utilization is such an important metric in FICO’s model that owing a lot of debt on an installment loan is almost always better than owing it on a credit card.
Alternatives to debt consolidation if you have bad credit
Debt consolidation might not be a viable option if you have a bad credit score because most methods for consolidating debt involve applying for a new credit account. You’ll need a good credit score to qualify for low enough interest rates to actually save money.
There are also sometimes extra costs associated with debt consolidation (such as balance transfer fees or loan closing costs), which may make it infeasible if you’re short on funds.
Given these disadvantages, it’s worth considering other ways to get out of debt:
Debt management plan
A debt management plan (DMP) is a debt-relief program offered by credit counseling agencies. When you enroll in a debt management plan, you work with a credit counselor who negotiates with your creditors to set up a more manageable payment plan for you.
They may be able to negotiate for:
- Lower interest rates
- Fee waivers
- Longer repayment schedules
- Lower monthly payments
Enrolling in a debt management plan is an indirect way of consolidating your debts because instead of continuing to make separate payments to each of your creditors, you’ll make a single monthly payment to the counseling agency. Your credit counselor will then distribute the funds to your creditors.
Make sure you choose a licensed nonprofit agency to work with, ideally one accredited by the National Federation for Credit Counseling (NFCC).
Debt settlement
Debt settlement is an agreement you make with your creditor where they accept payment for less than the full amount you owe and forgive the remaining debt. Debt settlement is different from debt management, even though they have similar names and are both debt-relief strategies.
You can hire a debt settlement company to settle your debts for you, but bear in mind that these companies usually charge a fee of around 20%–25% of the settled amount. 4
Alternatively, you can negotiate with your creditors yourself by sending a debt settlement letter.
401(k) loan
Many 401(k) plans allow you to borrow against your retirement savings. Like using a home equity loan to consolidate your debts, using a 401(k) loan is a very risky option.
401(k) loans have the following consequences:
- Reduction in your retirement savings
- Potential taxes or penalties if you can’t repay
- No forgiveness if you file for bankruptcy, unlike standard consumer debt
If unforeseen circumstances put strain on your finances and you can’t afford to pay back your 401(k) loan, you’ll compromise your financial security later in life. For this reason, you should consider this an option of last resort.
Bankruptcy
If your debt is overwhelming or you’ve simply run out of options, then you can always file for bankruptcy. However, you shouldn’t make this decision lightly—bankruptcy is the most damaging thing that can happen to your credit.
Bankruptcies can stay on your credit report for up to 10 years, depending on the type you apply for. There are two types of consumer bankruptcy:
- Chapter 13 bankruptcy: This gives you the opportunity to repay some or all of your debt over the course of 3–5 years. 5 This type of bankruptcy stays on your credit report for 7 years.
- Chapter 7 bankruptcy: This is the more damaging type of bankruptcy. In this case, a trustee will sell your assets to cover as much of your debt as possible, and the remainder will be forgiven. 6 Chapter 7 bankruptcies stay on your credit report for up to 10 years.
Even if you do file for bankruptcy, you can still fix your credit. It will take a long time, but bankruptcy will give you a fresh start and the opportunity to start building good credit habits.
