When you have multiple sources of high-interest debt, trying to pay it off could feel like trying to move a mountain. With debt consolidation, however, you could pay off your debt quickly to create a path toward a bright financial future. Still, before committing to a debt management plan, it is important to understand how debt consolidation could affect credit.
Camino Federal Credit Union has served Montebello with debt management products and guidance tailored to each member’s needs and situation since 1941. We partner with each member to help put debt in their rearview in route to financial success. Read our blog to learn how debt consolidation could impact your credit score.
What Is Debt Consolidation?
To stop your debt from growing in more than one area, debt consolidation is a strategy that combines debts that have accumulated over time in one place to pay back what you owe with a fixed payment schedule.
With debt consolidation, you are refinancing multiple high-interest unsecured debts into a new, larger debt that usually has a lower interest rate. If you decide to apply for a personal loan for debt consolidation, you could determine how much financing to apply for by summing up how much you need to pay off all your debts.
Debt consolidation could lower the total interest you owe on the debt and help you pay it off faster. After all, when it comes to convenience, wouldn’t you rather have one loan to pay off rather than multiple loans?
How Debt Consolidation Affects Credit
If you decide a debt consolidation loan is the ideal path to your financial freedom, you should understand that it could temporarily lower your credit score. That said, there are also several ways you could benefit from a debt consolidation loan.
During the application process, your credit is checked, which could lower your credit score for a short time. Consolidating multiple accounts into one loan could also lower your credit utilization ratio, which could negatively impact your score as well.
A good credit score could be beneficial as your credit status could impact many areas of your life. Consolidating your debt into one manageable payment, however, could improve your credit score long-term.
Timely payments and paying off your debt could also help improve your credit score. While this strategy is a viable option to repay your debt faster, many wonder how debt consolidation affects credit. We’ll explore the impact debt consolidation could have on your credit score below.
New Credit Applications
When you apply for a personal loan or balance transfer credit card to consolidate debt, the lender will perform a hard inquiry on your credit, which may lower your credit scores by a few points. Still, this will only be a temporary knock on your credit score.
A hard inquiry usually equates to less than a 5-point decrease in your score, and you should see your score rebound within a few months. Still, we advise only applying for loans for which you’ll likely receive approval and pre-qualifying when possible.
New Credit Account
Opening a new credit account like a credit card or personal loan may temporarily lower your credit score, as will closing credit accounts you have paid off. Still, debt consolidation could yield long-term benefits to your credit score.
First, adding a debt consolidation to revolving lines of credit could improve your credit mix and boost your score. However, lowering your total available credit and reducing the length of your credit history affect your credit score, too.
By consolidating debt, you will lower the average age of your accounts, which could initially hurt your credit score. But over time, this average will increase and your score will improve, especially if you avoid opening new credit accounts unless you need them.
Lower Credit Utilization Ratio
The credit utilization ratio is a measure of how much available credit you’re using. Once you open a debt consolidation account, this could drop and increase your available credit, improving your credit score.
With a debt consolidation loan, you are closing out multiple accounts and lines of credit and rolling them into a single loan, both of which usually have a positive impact on a credit score, as will continuing to pay off debt and improving your credit utilization ratio.
If you use a loan to pay off credit card debt, for example, you will bring your utilization ratio down to zero on that card, which could help improve your credit score.
Also, debt consolidation loans are considered installment credit, while credit cards are considered revolving credit. Revolving credit generally has a larger impact on your overall utilization ratio than installment credit does, which is another way these loans could boost your score.
Improved Payment History
Your payment history is one of the biggest determining factors in how debt consolidation affects credit. If you diligently make payments on time, you may see your credit score increase over time. Your payment history is an important factor in determining your credit score.
Consolidating your debt into a new, lower-interest loan may hurt your credit score in the short term, but you could enjoy long-term benefits to your credit with time.
By consolidating loans, you combine outstanding payments into a single monthly payment, which will make it far easier to manage and also reduces the chances of making late payments or missing payments altogether.
With a debt consolidation loan, you could also enjoy a fixed payment schedule so you will know exactly when you could expect to finish paying off debt, which many types of revolving debt don’t offer. This payment schedule could also make budgeting and managing your finances easier.
If you make regular, punctual payments and pay off your debt consolidation loan in a reasonable amount of time, your credit score should recover quickly as you improve your credit utilization ratio and may even improve in the long term as you pay down your debt and establish a solid payment history.
Do You Need Help With Your Debt? Let Us Know!
So, the answer should be clear for those wondering how debt consolidation affects credit. While it may temporarily lower your score, in the long run, taking out a personal loan for debt consolidation could be a great way to pay down your debt, improve your credit score, and lay the foundation for greater financial success. Visit our Debt Consolidation Loans page to learn more about this program and apply for financing to put yourself on the fast track to a bright financial future.