Debt consolidation can sound intimidating, or something that requires professional help. But you may use a debt consolidation strategy to save a decent amount from your monthly debt payments. If used properly, a debt consolidation option can be a helpful tool for managing debts when you find it difficult to manage multiple debt burden and due dates.
There are multiple ways to do that. Some borrowers may take out a personal loan and pay off multiple debts. Some might transfer their credit card balances into a newer card with a low interest rate or a 0% APR.
In addition to making your debt easier to manage, debt consolidation can be helpful to your credit score, too.
Melinda Opperman, executive vice president of Credit.org (a nonprofit consumer credit counseling agency) added –
Melinda Opperman, executive vice president of Credit.org (a nonprofit consumer credit counseling agency) added –“If you consolidate multiple other debts into a new personal loan, your credit score would likely be improved. You would free up available balance on all of the debts you transfer to the new loan.”
How debt consolidation loan may affect your credit score
a. One monthly payment makes it easier to manage payments
When you consolidate multiple debts with a debt consolidation loan, what you’re left with is one new monthly payment instead of several payments to keep track of. As a result, you may be more likely to make on-time payments, which will help you improve your credit score.
b. It may be easier to budget
If you’ve missed payments in the past, which hurt your credit score, it could be because you’re constantly juggling different minimum payment requirements with different due dates. Some months, you may not have enough on hand when your bills are due. When you use a personal loan to pay off your debt, you take out a personal loan at a fixed rate and a fixed repayment term. Because the rate and term are fixed, you’ll know exactly what your monthly payment will be each month and how long it will take to pay it off, so you can budget accordingly.
c. You’ll decrease your credit utilization ratio
If you use that new debt consolidation loan to pay off high-interest debts, it can also help you pay off debt faster because you won’t be accumulating as many finance charges.
And, as the balances on those debts fall, so does your credit utilization ratio. Your utilization ratio refers to the amount of credit you have used over the total amount of credit available to you on your cards. Credit utilization counts for 30% of your FICO score. The higher your utilization, the more damage it can do to your credit score.
Ideally, you should aim to use no more than 20% to 30% of your overall credit limit, but that’s not always easy if you’re struggling to keep up with multiple debts.
D. You can pay off delinquent debts
The consolidation loan may help you pay off some outstanding balances or delinquent debts, causing your score to improve. You can consolidate debt without affecting credit score for most types of unsecured consumer debt, including credit cards, medical bills, utility bills, payday loans, private student loans, taxes, along with delinquent debts that have gone to collection.
Delinquencies negatively impact the payment history part of your FICO calculation depending on how late they were, how much you owe, how recent a delinquent account is and how many delinquencies you have. Based on your current data, your score improvement may vary.
e. You can diversify your credit file
Opening a personal loan can add some diversity to your credit mix, which accounts for 10% of your FICO credit score. When you take out a personal loan, an installment account will be added to your credit report. It’s beneficial for your credit score if you have a mix of credit, including both revolving credit accounts (credit cards) and also installment credit accounts (personal loan).
The personal loan is installment debt, not a revolving line of credit like a credit card, so having the new debt on your credit report would have less of a negative impact on your credit score, Opperman told MagnifyMoney.
How debt consolidation loan can hurt your credit
Debt consolidation can boost the credit scores of consumers struggling to manage several debts such as high-interest credit card debt, medical debt, and student loans — if used properly. That said, there are some scenarios in which consolidation could, in fact, cause more harm than good to your credit score.
a. You may see a minor hit to your credit score
When you apply for a personal loan, the creditor has to pull your credit report to approve your loan request. They do what’s called a hard pull, which will add an inquiry to your credit report. This will cause your credit score to dip a bit, as new credit inquiries account for about 10% of your FICO credit score. But, your credit utilization will account for 35% of your credit score. So, you’ll get a minor hit on your credit score due to the loan application initially. But once you pay off all credit card debts in full with the loan, your credit utilization ratio will be reduced and should benefit your score more.
You can avoid adding several inquiries to your report by getting prequalified for a loan. When you are prequalified, the creditor does a soft pull of your credit report to see if you are likely to meet the criteria for a loan. The soft pull does not result in an inquiry added to your credit report, so your score won’t take a hit.
It’s important to note: Being prequalified for a loan does not mean you will be approved once you submit an application, or that you will receive a loan on the terms you were prequalified for. But, it does allow you to shop around and compare your options before applying.
b. It can be easy to get into even more debt
Using a personal loan to consolidate your credit card debt can be risky, especially if you don’t know how to keep bad spending habits away from you. Too much spending may put more debt load on your shoulder. More debt means further damage to your credit score. The danger comes not with the personal loan itself, but what happens after you use it to pay off your old debts. If you use it to pay off credit cards, for example, you may be tempted to start running up charges on those cards again.
“If you start using the freed-up revolving debt balances to spend, you will be right back where you started, and worse,” said Opperman. “A personal loan for debt consolidation can help, but you have to be fully committed to paying on time and not increasing your revolving debt balances.”
Creating and following a budget can help to combat poor spending habits. If you think it may be too difficult not to use your cards, cutting them up or literally freezing them by placing them in a plastic bag with water and sticking it in the freezer can help make it more difficult to use them. Some credit card issuers allow you to lock and unlock your cards online or by using an app. Having to unlock your card to use it can act as an additional step in preventing overspending.
When used properly, debt consolidation can be extremely helpful to your credit score. The terms you receive on a debt consolidation loan is largely dependent on your credit rating and the debt-to-income ratio at the time you apply. The method could backfire if you haven’t yet resolved your reason for racking up debt in the first place. But, if you use a debt consolidation loan with the intention to become debt-free, debt consolidation could significantly help your credit score.