Does Debt Consolidation Hurt Your Credit Score?

Debt consolidation is often a strategic move for those feeling overwhelmed as they manage various monthly debt payments. Borrowers aim to lower their overall interest rate and simplify their finances by combining multiple debts into a single loan or payment plan.

So, how does debt consolidation affect your credit score, if at all? Like many actions related to your finances, debt consolidation can cause a push-pull on your credit score. It can improve some credit factors while working against you in other areas.

If you’re exploring options to consolidate debt, take a little time right now to learn about how credit works, the various approaches to debt consolidation and the ways each approach can benefit or hurt your credit score and overall credit situation.

What Impacts Your Credit Score?

Familiarity with the various factors that impact your credit score can benefit anyone considering a debt consolidation loan or simply looking to manage their finances more effectively. Let’s quickly review the five factors that influence your FICO^® credit score and the weight they each carry:

• Payment history (35%): This reflects the timeliness of debt payments and is the most significant factor in determining your credit score. Consistent on-time payments can improve your score, while late or missed payments will negatively affect it.
• Amounts owed (30%): Often called your utilization ratio, this indicates how much available credit is being used. Keeping this number below 30% demonstrates responsible credit management and can positively influence your score.
• Length of credit history (15%): This factor shows the duration of your credit activity. A longer credit history suggests reliability and stability, which contributes positively to your credit score.
• Types of credit in use (10%): This represents the diversity of the credit in your credit portfolio. A mix of credit types – such as student loans, credit cards and a mortgage – signals to lenders that you can manage various forms of credit.
• New credit and inquiries (10%): This signals the frequency of your credit applications and the age of your credit lines. It’s best to minimize applications and inquiries since frequent applications can signal financial distress.

Checking Your Credit Report

Not sure where you stand on your credit? Getting a credit report is easy when you know where to look. You can obtain one free credit report each week from each of the three major credit bureaus: TransUnion^®, Experian^® and Equifax^®. For convenience, you can request a copy from all three agencies at AnnualCreditReport.com.

Previously, the national credit bureaus provided a free credit report only once a year, but this changed during the pandemic and the move to free weekly reports from each of the three bureaus has since become permanent.

When Should You Consolidate Debt?

Debt consolidation can be a tremendously helpful move for those looking to streamline their finances. One goal of debt consolidation is to combine multiple accounts into one, simplifying to one monthly payment and, ideally, reducing the amount of interest paid over time. However, understanding when to consider debt consolidation and the different methods available is crucial to achieving your financial goals.

Different Types Of Debt Consolidation And How They Affect Your Credit

The best consolidation method depends on your financial situation, your personal goals and the types of debt you hold. Highlighted in the table below are the four types of tools used most often for debt consolidation.

Each method has advantages and potential drawbacks, depending on your credit score, the nature of your debts and your financial needs. Selecting the right approach requires careful consideration of your long-term financial health and the specific goals you aim to achieve through debt consolidation.

Remember that applying for any new line of credit triggers a hard inquiry into your credit, which will reduce your credit score by a few points. This will usually be the first way your credit is affected by any credit-based approach to consolidating debt. Of the options outlined below, only a debt management plan does not require a hard credit inquiry.

Personal Loans For Debt Consolidation

Personal loans offer a straightforward approach to debt consolidation, allowing individuals to replace multiple debt payments with a single monthly payment owed to one debt consolidation loan. Ideally, the new personal loan will have a lower interest rate than the average of the existing debts, thereby reducing the overall cost of repayment.

How A Debt Consolidation Loan Can Hurt Credit

While a personal loan can be a great option for debt consolidation, this method can negatively affect your credit score in a few ways:

• Credit utilization: Taking out a personal loan, in and of itself, won’t affect your utilization. That’s because personal loans are a form of installment debt, not revolving debt as in the case of a credit card. However, when a personal loan is used to pay off revolving debt, it could have a negative impact on your credit utilization ratio and, ultimately, your credit score. For example, you might pay off one credit card but end up utilizing considerably more of the available credit on another card, which could negate the benefits you were originally striving for.
• Account closure: Closing old accounts can reduce available credit and remove established credit history, potentially lowering your credit score. If you’re paying credit card debt, try to pay off your balance without closing the account.

Credit Card Balance Transfer

Credit card balance transfers involve moving outstanding credit card balances to a new credit card that, in most cases, offers a lower interest rate or a promotional period with zero interest. You’ll generally pay a balance transfer fee of 3% – 5% when you open your balance transfer card.

How A Balance Transfer Can Hurt Credit

The low fees or low APR associated with a balance transfer can be very enticing, but before you go this route, review the ways it can affect your credit:

Home Equity Options

Home equity options, such as a home equity loan, home equity line of credit (HELOC) and cash-out refinance can all leverage the equity in your home to consolidate debts. These methods often come with a lower interest rate than an unsecured loan or credit card, offering a cost-effective way to manage debt. But keep in mind that you’re using your house as collateral to secure this type of financing.

How Home Equity Options Can Hurt Credit

If you have a significant amount of equity in your home, a home equity loan, HELOC or cash-out refinance might be the right choice for you. But don’t forgot to consider the possible impact to your credit score due to:

Debt Management Plan

A debt management plan (DMP), often facilitated by non-profit credit counseling agencies, consolidates credit card debt into a single payment. Unlike other consolidation methods, DMPs don’t require new credit. Instead, they work by negotiating interest rates with creditors on your behalf.

During the plan, you make one payment to the credit counseling agency, from which they pay your creditors monthly. In addition to lowering your overall interest rate and monthly payments, these organizations offer budget guidance and housing counseling.

How Debt Management Plans Can Hurt Credit

Using a DMP sometimes comes with fewer risks than other forms of debt consolidation. However, a DMP can still damage your credit due to:

The Bottom Line: Know How Debt Consolidation Will Affect Your Credit

Debt consolidation can influence your credit score and credit profile as a whole in various ways, depending on the method chosen and your financial decisions post-consolidation. While the initial effects may include a temporary dip in your credit score due to a hard inquiry, the long-term benefits – such as lower payments, an improved credit utilization ratio and a simplified payment – can outweigh the drawbacks.

If you want more insights into your finances, download the Rocket Money℠ app. Track your spending and saving while monitoring your debt repayment progress all in one place.