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Does debt consolidation hurt your credit?
Debt consolidation can provide much-needed relief if your monthly payments have become overwhelming. While a bit of extra wiggle room in your budget can be a good thing, there's also the question of how consolidating your debt can impact your credit. This becomes a more pressing question if you've had financial missteps in the past and are working to rebuild your credit.
Before you consolidate debt, here's what to consider and how your decision may impact your credit.
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What are your options for consolidating debt?
When you consolidate your debt, you combine multiple loans into a single account (ideally, one with a lower interest rate). Say you have four credit cards with a total balance of $16,000. You might decide to take out a $16,000 loan, use those funds to pay off your credit cards, and then benefit from a single monthly payment. In essence, you're combining your debt into one loan to make your payments easier to manage.
You have a few options if you're considering debt consolidation, including:
Personal loan
A personal loan is a popular choice for consolidating your debt. Many banks and credit unions offer these loans, which typically have fairly low rates and don't require collateral like a car or home loan. Personal loans often have repayment terms as long as five or seven years, and while borrowing requirements vary by lender, you might qualify for one of these loans with fair credit.
Read more: How to consolidate credit card debt with a personal loan
Balance transfer credit card
A balance transfer credit card with a 0% introductory APR is another way to consolidate debt. Typically, you'll need good or excellent credit to qualify for this type of credit card.
But if you can get approved and transfer your balances from high-rate credit cards, it could save you significantly on interest, assuming you can pay off your balance in full before the 0% introductory APR expires. Intro APR timeframes differ, but many cards offer a 0% rate for up to 12 or 18 months.
Read more: How to pay down debt using a balance transfer credit card
Home equity loan or line of credit
If you own a home and have paid down your original mortgage significantly, you could also tap into your home equity. A home equity loan lets you borrow a lump sum, while a home equity line of credit (HELOC) gives you access to a flexible credit line. Both tend to have lower rates than personal loans, though your rate will vary depending on your credit. Borrowing requirements also vary, though lenders typically require good credit to qualify for a home equity loan or HELOC.
But unlike an unsecured personal loan, a home equity loan or HELOC is secured by your home, which is used as collateral. For this reason, you'll want to be absolutely sure you can afford your monthly payments. If you default on the loan, the lender could repossess your home.
Read more: How to use a HELOC to pay off debt
How does debt consolidation impact your credit?
Debt consolidation may help boost your credit in the long term, but in the short term, you could see your credit score dip. Here's how it might help versus hurt your credit:
Hard credit check: You'll undergo a hard credit check if you apply for a new credit card, personal loan, home equity loan, or HELOC. This check could temporarily reduce your credit scores by a few points. The more hard credit checks you have in a short timeframe, the larger the adverse effect. For this reason, it's smart to avoid opening several new accounts when consolidating debt. Instead, focus on one loan or one balance transfer card with a 0% introductory APR.
Credit utilization: Your credit utilization is the amount of credit you're using relative to what's available to you, and it can have a big impact on your credit scores. Generally, the lower your credit utilization, the better. If consolidating your debt helps reduce your credit utilization, it could help your credit scores. Note that your credit utilization will generally decrease as you pay down your balance after consolidation, so even if it increases initially, your credit could still improve over the longer term.
Account age: Opening a new credit card or loan will reduce your average account age, which also affects your credit score. The older your accounts, the better your credit is likely to be. For this reason, it often makes sense to avoid closing your old credit cards. Closing them could reduce your average account age even more, resulting in further declines to your credit score.
Credit mix: Your credit mix also factors into your credit score, though it's not as influential as your payment history, credit utilization, or length of your credit history. Your credit mix is the combination of your credit accounts, such as credit cards, student loans, or a mortgage. If, for example, you consolidate your credit card debt with a personal loan and didn't have outstanding loans previously, it may help your credit mix — and consequently, your credit scores.
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When does debt consolidation make sense?
A debt consolidation loan could be smart if you're struggling to manage several monthly payments and you want to simplify your financial situation. It's also a wise choice if you have debt across high-interest credit cards and want to consolidate with a personal loan, a 0% introductory APR credit card, or a home equity loan or HELOC. Doing so could save you big money on interest in the long term.
If your goal is to improve your credit over the long term, consolidating your debt could also help you do so, provided that you remain disciplined with your spending and monthly payments.
Keep in mind you'll likely need good credit to qualify for a 0% introductory APR card, a home equity loan, or HELOC. Some personal loan lenders may be willing to work with you if you have fair credit, but shop around for options because not all lenders accept fair credit scores.
This article was edited by Alicia Hahn.
