How does a debt consolidation loan affect your credit score?

Can you consolidate debt without affecting credit score

How does a consolidation loan to repay debt affect your credit score?

If you’re in huge credit card debt and you’re looking for a way to get out of it, you can consolidate your debts.

The debt consolidation option can be a helpful tool for managing your debts. Debt consolidation helps you combine all your unsecured debts and merge them into a single monthly payment.

There are multiple ways to consolidate debts.

  • You can consolidate debt on your own by taking out a personal loan or home equity loan.
  • You can transfer your credit card balances into a newer card with a low interest rate or a 0% APR.
  • You can also enroll in a consolidation program to consolidate your debts.

But, only finding out a debt solution is not enough, you should understand that every consolidation process has an effect on your credit score.
So, before considering debt consolidation, know how the various debt consolidation processes affect your credit health.

Ways in which paying off debts with a consolidation loan improves your credit score

The fact that worries most debtors is whether or not debt consolidation loans can have a trashing effect on their credit score. However, paying off debts with a consolidation loan can improve your credit score.

Usually, debt consolidation loans don’t hurt your credit score initially since it has a hard inquiry on your credit report. But, it helps you to repay your past dues. Thus, you will see a positive change in your credit score when you repay your existing debts along with the consolidation loan on time.

1. One Monthly Payment Makes It Easier To Manage Payments

When you consolidate 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 add a positive item on your credit report and can help you improve your credit score.

2. You can avoid late payments

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 the 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 and avoid late payments.

3. You’ll decrease your credit utilization ratio

If you use a 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 many finance charges.

And, as the balances on those debts fall, so does your credit utilization ratio. This 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 about 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.

4. 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 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, which is a 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.

5. 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 an 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, as Opperman told MagnifyMoney.

Ways in which paying off debts with a consolidation loan hurts your credit score

Debt consolidation loans 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. But, there are some scenarios in which paying off debts with a consolidation loan can hurt your credit score.

1. Hard inquiry can gulp 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 a hard inquiry to your credit report. This can 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 and other dues 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. Also, multiple inquiries in a 45-day period is considered to be 1 inquiry.

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.

2. It can be easy to get into even more debt

Using a consolidation 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 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.

Note: Paying off debt through a consolidation program has no negative affect on your credit score. It won’t hurt your credit score at all as you will make regular payments and repay all your debts completely.

Lastly, paying off your debts through debt consolidation will reveal your willingness to repay your financial dues. 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 to improve your credit score.

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By Valentina Wilson on August 26, 2020

Valentina Wilson is a writer and blogger who specializes in personal finance and positive change and associated with BestDebtConsolidation. She has a master’s degree in financial journalism and seven years of experience in personal banking and believes that small behavioral changes are the key to achieving financial freedom.

Follow her on Twitter: @valentinailson