Does Debt Consolidation Help or Hurt Your Credit Score?
by The Ascent Staff | Aug. 4, 2019
Debt consolidation can help you save money, but one wrong move, and it can damage your credit score.
Debt consolidation can help you get out of overwhelming debt, but it may affect your credit score in surprising ways. The type of debt consolidation you choose and the habits you keep afterward will determine what happens to your credit score.
How debt consolidation works
If you're up to your neck in debt, consolidating your debts you owe into one loan may seem logical. You use the proceeds of either a personal loan or a balance transfer credit card to pay off your existing debts. This leaves you with one monthly payment to manage and, if you do it right, a lower interest rate.
The type of loan you choose determines how you pay the debt back:
- Personal loan: You make fixed installment payments with a fixed interest rate over a set term.
- 0% balance transfer credit card: You make at least the minimum required payment each month. You should try to pay the balance off during the promotional period, though. If you don't, the issuer will charge interest on the remaining balance.
How consolidating with a personal loan can help your credit score
You can get a personal loan at your local bank, online bank, or through a peer-to-peer lender. Each bank or lender charges different interest rates and fees. Make sure you read the fine print so you understand what the lender charges. You should also pay attention to the loan's APR so you can compare loans effectively.
A personal loan can help your credit score in the following ways:
- A history of on-time payments: Payment history makes up 35% of your credit score. By simplifying your payments into one monthly payment, it may be easier to make your payment on or before the due date.
- A lower credit utilization ratio: Your amounts owed, or credit utilization ratio, makes up 30% of your credit score. Paying off your credit cards (and keeping them open) will lower the amount you owe compared to your available credit, which is good for your credit score.
- A more diverse credit mix: Your credit mix makes up 10% of your credit score; adding an installment loan to the mix of revolving debt helps mix things up.
How consolidating with a personal loan can hurt your credit score
Here are some of the ways a personal loan can hurt your credit score if you aren't careful:
- It opens up more credit: With your credit card balances gone, you have more credit available to spend. Using your available credit can undo the benefits of consolidating debt.
- It lowers your average account age: The average age of all your credit accounts makes up 15% of your credit score, and the higher it is, the better. Adding a new account will bring the average age down, temporarily lowering your credit score.
- It creates a fixed payment: If you can't afford the monthly payment, your lender could report your payment as 30 days late (or longer) to the credit bureaus. Even one late payment can negatively affect your credit score.
How consolidating with a balance transfer credit card can help your credit score
Finding the right balance transfer offer is important, whether you use your current credit card company or find a new one. Compare your options, paying close attention to the terms, such as length of the intro period and the rewards offered. As with a personal loan, always read the fine print to understand the terms and fees of the credit card, such as late-payment fees, annual fees, or over-the-limit fees.
The right balance transfer credit card can help your credit score in the following ways:
- It lowers your credit utilization ratio: Opening up a new credit line decreases your total outstanding debt compared to your total available balance.
- It simplifies payments: With only one payment to make each month, you may have an easier time avoiding delinquent payments in the future.
- It eliminates delinquent, high-interest debt: If you're behind on your credit card payments, wrapping that delinquent debt into your balance transfer credit card eliminates the delinquency. While the late payments you made won't disappear off your credit report, timely payments on the new credit card can help your score increase.
How consolidating debt with a balance transfer credit card can hurt your credit
Balance transfer credit cards may seem perfect, especially if you can snag a 0% APR and/or attractive rewards, but they can harm your credit score if:
- You max out your balances: If you use most of the balance transfer credit line extended to you, the high balance will cause your credit score to drop.
- The card significantly decreases your credit age: A new credit card decreases your average account age.
- Your credit limit isn't high enough: If you can't get a high enough credit limit on your balance transfer card, you won't be able to transfer all of the debt from your other credit cards. You want the new card's credit limit to be high enough to zero out your existing credit card balances and to lower your utilization ratio.
Using your credit wisely
Whether you choose a personal loan or balance transfer credit card for consolidation, the important thing is how you handle the paid-off credit cards. You should leave the credit cards open but untouched. Put them somewhere safe where you know you won't use them but can leave them open.
The open credit cards help your credit age stay high and keep your utilization rate low. You need self-discipline to make sure you don't rack up the same credit card debt again. If you rely on credit cards for essentials or to make purchases you otherwise couldn't afford, you may want to cut them up and close the account. Credit counseling from a non-profit organization can also help you rehab your financial habits.
Should you consolidate your debt?
Debt consolidation should have an overall positive impact on your credit score if you do it right. Weighing all of your options and paying close attention to the associated fees can help you make the decision that will get you out of debt with the least amount of fees or interest charged.
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