How does debt consolidation affect your credit score?
If you have multiple high-interest credit card balances, debt consolidation is a great way to lower your monthly payments and improve your credit. The way this works is you use a single loan to pay off the balances of your credit cards or other loan balances. You then only have to make one monthly payment. Additionally, you may be able to get a loan with a lower interest rate.
There are four different ways you can consolidate your debt:
- A personal loan: Using a personal loan with a lower interest rate, you can pay off your high-interest credit card balances, allowing you to pay off your debt faster. Even some personal loans are designed for debt consolidation, such as the ones offered by Lending Arch.
- Balance transfer credit cards: These types of credit cards offer introductory periods where they provide a low or no interest on balances transferred from another card within a set period. As a result, you have the opportunity to save on interest and make more progress paying off your debt.
- Home equity loan: If you’re a homeowner and you’ve built up an ownership stake in your home, you may be able to take out a loan by using your home as collateral. In general, these loans usually offer lower interest rates than credit cards or personal loans. However, if you don’t pay this loan back, you could lose your home.
- Retirement account loan: If you have a retirement savings account, you may be able to take a loan from it to pay off your debt. However, you’ll need to be careful to pay the loan back according to the retirement plan’s rules, or you could face taxes and penalties.
The Benefits of Consolidating your Debts
Debt consolidation is a good way to save money. For instance, if you have credit card debt that’s charging you 20% or more in interest and you consolidate this debt into a new credit card or loan with a lower interest rate, you’ll save money.
Consolidating your debt is also a good way to simplify your payments. When you have multiple accounts to handle, it’s more likely that you’ll make a mistake and miss a payment. When you miss a payment or send in a late payment, this affects your credit score. Therefore, consolidating everything into a single monthly payment can help protect your credit.
How Consolidating your Debts Affects your Credit Score
When you consolidate your debt, you’ll be both helping and harming your credit. Here are some of the ways your credit is affected when you consolidate your debt:
- Applying for new credit: Before you even consolidate, your score can be affected. This is because when you apply for a loan or balance transfer card, the lender will perform a hard inquiry on your credit which will lower your score by a few points.
- Opening a new credit account: When you open a new credit account, this temporarily lowers your credit scores. This is because lenders look at new credit as a new risk, so your credit score will dip temporarily when taking out a new loan.
- Lower average age of credit: As your credit accounts age and they demonstrate a positive history of on-time payments, your credit score will rise. However, when you open a new account, this lowers your average account age and may lower your credit score for a while.
- Better payment history: It will be gradual, but as you make payments on your new loan on time, your credit score will slowly begin to rise. This is because your payment history is the most significant factor in your credit score.
- Lower credit utilization ratio: This ratio is a measure of how much of your available credit you’re using. As a result of consolidating your debt, this ratio may fall because your available credit will increase.
In the short or medium term, consolidating your debt into a personal loan, a balance transfer credit card, home equity loan, or retirement account loan will affect your credit scores both positively and negatively. Your credit score may be negatively affected because lenders perform a hard inquiry when you apply for new credit. Additionally, a new credit account is seen as a new risk, and it lowers your average account age. As a result, your score will temporarily go down. However, debt consolidation also positively affects your credit score because your payment history will improve, and your credit utilization ratio will get lower.