Debt consolidation is one of the options people consider to address their outstanding debts. Combining all your credit card and other debts into a single, new loan can help you get on the path to becoming debt free. One loan means a single debt payment to contend with every month, not a half dozen or more due at different times. Making one payment each month helps to streamline your debt repayment process and makes it less likely that you’ll forget a bill.
A good debt consolidation loan will also be issued at a lower interest rate than what you’re currently paying on other outstanding debts, too. This helps to eliminate the challenge many borrowers have with minimum payments on their credit cards, as paying the bare minimum each month does little to chip away at the card’s overall balance. The new loan’s lower interest rate reduces the interest expenses accrued on the outstanding debt over time, which decreases the rate at which the principal is building up.
When considering debt consolidation, one issue to worry about is how any new loan will affect your credit. Requesting a debt consolidation loan and taking on additional debt will almost certainly affect the way credit-reporting agencies view overall credit worthiness. The loan itself, and how you put it to use, can have an impact on your credit as well. Let’s look at the impact debt consolidation loans can have on your financial situation and determine whether a debt consolidation loan hurts or helps your credit.
So, How Is Your Credit Anyway?
Prior to choosing an option such as debt consolidation to address your outstanding debts, you should assess the current state of your credit. Three primary credit-reporting agencies compile and monitor consumer credit data: Experian, TransUnion, and Equifax. Lenders use this data to make decisions about whether to extend credit to prospective borrowers. In some cases, how these credit-reporting agencies assess your credit rating will limit the options available to deal with all your outstanding debt.
You can order a free credit report every 12 months to assess the status of your credit. Many banks and financial services companies also offer free, real-time access to your credit score as well. You should make use of these services, especially when you’re considering a debt consolidation loan. Reviewing them after you’ve been paying on your debt consolidation loan for some time is useful as well, since it’ll help you assess the effects your loan is having on your credit.
Reviewing your credit report prior to applying for a debt consolidation loan can actually help protect your credit. Your credit may not be good enough to quality for a loan, and finding that out ahead of time can stop you from needlessly applying for one, which can impact your credit score (as we’ll discuss later). Additionally, if you determine that a debt consolidation loan isn’t currently feasible, you can start working to improve your credit so you can apply for a loan later, or select a different option to start addressing your debt today.
The Debt Consolidation Loan Application
If you decide to obtain a debt consolidation loan, the first thing you’ll have to do is apply for one. When you do so, the lender will likely initiate a hard credit inquiry. A hard credit inquiry is a formal review of your credit rating. Each credit inquiry that’s performed can cause a slight decrease in your overall credit score, and multiple inquiries on your credit, or multiple loan rejections, can lower your credit score significantly.
The free credit check discussed earlier is really worth your time here. Order a credit report and read it prior starting the loan application process as you prepare to shop around for loans. If your credit rating is problematic, you should attempt to improve it before applying for any debt consolidation loan. If you have poor credit, consider other options to deal with your outstanding debts, such as the debt settlement services that National Debt Relief offers.
If you’re concerned about the effects that applying for a debt consolidation loan may have on your credit, you can consider non-traditional lenders, too. Most peer-to-peer (P2P) platforms, which link prospective borrowers with private investors who are willing to lend them funds, don’t execute hard credit inquiries prior to issuing debt consolidation loans.
If you have a 401(k) retirement account, you may also be able to borrow from that account to consolidate your debt. Since you’re borrowing money from your own retirement account, a 401(k) loan doesn’t require a credit check. Finally, informal loans from family or friends don’t normally entail credit checks, so they won’t affect your credit rating, either.
Making the Loan Payment
A debt consolidation loan will definitely streamline the process for managing your debt. After combining all your old debts into the new loan, you’ll just have one payment to track and worry about each month. However, it’s still a payment, and you still have to make it. If you’re late on your debt consolidation loan payment, it could definitely hurt your credit rating.
In fact, not paying your debt consolidation loan on time can have a significant negative impact on your credit in a very short period. When it comes to your credit score, payment history, meaning how well you pay your bills on time, is extremely important. Your ability to pay bills on time consistently comprises over a third of your overall credit score, the most significant of the five factors that the three credit-reporting agencies use to compute your score. One inadvertent late payment on your debt consolidation loan can drop your credit score quickly, and multiple late payments can sink it virtually into oblivion.
However, when considering debt consolidation, it’s important to note that payment history works both ways when it comes to credit. If you do consistently pay your debt consolidation loan on time, it can help improve a weak or average credit score. Many borrowers find that they become more consistent about making payments after consolidating their debts into a single loan, too. If you’re confident in your ability to repay a new loan and need something to help simplify all your monthly credit card payments, then a debt consolidation loan might be a good option for you and your situation.
Erasing Bad Debt
One way a debt consolidation loan can help to start repairing your credit is by erasing some of the “bad debt” that you have. Millions of borrowers have lost control of their finances and are in arrears on multiple debt accounts. In 2014, it was estimated that over 35% of Americans had some sort of debt that had gone into collection. Delinquent accounts can have a devastating effect on credit ratings. Debt consolidation loans can help borrowers dig themselves out of holes like this and get their finances in good order.
Borrowers who are seriously behind in debt payments can use their debt consolidation loans to pay off delinquent accounts. They can also take care of all the penalties and fees that have accumulated on these accounts. Restoring delinquent accounts to a zero balance will gradually improve the very important payment history score factor mentioned previously, and this can help put you on the path to improving your credit rating. The key word here, however, is “gradually.” It can take months or even years for your credit score to improve substantially after paying off a delinquent credit card or loan account. Don’t expect to use your credit for anything important immediately after paying off a delinquent debt.
Finally, if you do have significant delinquent debts, paying them off with a debt consolidation loan may not even be an option. Due to your bad debts, you may not have the credit required to get a debt consolidation loan in the first place. If that’s the case, you’ll need to make an alternative plan to address your outstanding debt and get back on track.
Once you combine all your credit card balances into the new debt consolidation loan, all these cards will be at zero balance. This is a key step on your way to becoming debt free. Credit cards with low or no balances on them are also good for your credit rating, since they improve your overall credit utilization.
Credit utilization, meaning the amount of available credit a person has borrowed, is one of the five factors used to compute your overall credit score. Credit utilization is important, as it constitutes about a third of your overall credit score. Therefore, when you consolidate all your debt into the new loan, thereby leaving your old credit cards with no balances, this could immediately help to improve your credit.
Ensure you keep those credit cards open after transferring the balances to your debt consolidation loan, however. Closing out the cards decreases the overall credit you have available and will affect your credit utilization factor. While this seems counterintuitive, closing out those old cards in an attempt to manage debt will actually harm your overall credit score. However, be sure to put those cards away or cut up the plastic, because using them after you’ve consolidated your debt will also affect your credit utilization rate.
Budgeting Your Way to Better Credit
One of the reasons people are saddled with so much debt, and the average to poor credit that goes along with it, is because they fail to plan. Most Americans don’t have any sort of budget whatsoever; a staggering 70% of us don’t even have $1,000 in the bank to cover unexpected expenses. If you’re one of the people who manage finances by the seat of your pants, debt consolidation might help you manage your money more deliberately and improve your credit at the same time.
When you consolidate all your debts, you’ll only have to deal with a single payment to the lender each month. This will put your debts back into proportion with the rest of your bills. It should also make it much easier to make a monthly budget, since you can now precisely track your debt expenses. A budget can help you stay on top of your bills each month and decrease the chance of a missed payment. It’ll also help you focus on chipping away at the balance you owe on your outstanding debts. As your budget helps you establish a consistent payment history and pay down your outstanding debt balance, your credit will gradually improve, too.
However, your budget will only help your credit and debt situation if you follow it. Many people prepare a budget and start with the best intentions, only to ignore their plan when it comes time to make snap purchasing decisions. Other people don’t adjust their budget based on the reality of the situation and fail to account for decreases in salary or unexpectedly higher monthly expenses. As a result, they end up saddled with more debt and a lower credit rating than when they started. So, stick to the plan if you want to succeed!
A few of the more unique debt consolidation loan options have characteristics that can indirectly improve your credit rating. A home equity line of credit (HELOC) provides a good example of this. If you consolidate debts with a HELOC, you may be able to claim the interest you pay on the loan on your Federal income taxes. The tax savings realized from this can be applied toward the principal on your loan, which will reduce your outstanding debt and help to improve your credit.
If you take out a loan from your 401(k) retirement plan to consolidate your debts, credit-reporting agencies won’t consider that a traditional debt, such as a loan from a bank. You’ll therefore be able to consolidate all your credit cards without, at least in the eyes of the credit-reporting agencies, taking on additional debt. This will allow you to streamline your debt repayment efforts without any significant impact to your credit rating.
While these unique debt consolidation options provide some indirect benefits, there are also unique risks associated with both of them. Borrowers who fall behind on a HELOC put their homes at risk, as lenders can potentially seize any property that was used to secure the loan if the borrower is delinquent on the payments. Additionally, borrowers who use a 401(k) loan may be subject to early withdrawal, tax, and other penalties, and may not accumulate enough value in their 401(k) to retire on time because of the loan. Borrowers should take all the benefits, along with the risks, into consideration prior to choosing one of these two debt consolidation options.
Diversity Is Strength: Debt Consolidation and Credit Mix
Many people use debt consolidation to address high levels of outstanding credit card debt. This makes total sense, as the average American household is carrying credit card balances totaling $16,000 from month to month. A balance that high leads to a significant amount of interest expenses each month, so it’s not surprising that debt consolidation is such a popular option these days. However, using a debt consolidation loan to dispense with high credit card balances can sometimes help borrowers improve their overall credit as well.
Credit mix is another factor the various credit-reporting agencies use to calculate a person’s credit rating. The credit bureaus view borrowers who successfully manage multiple types of debt such as credit cards, auto, and home loans more positively than those who only have credit cards and are having trouble with the balances on them. Taking out a new debt consolidation loan can help broaden your credit mix and have a positive impact on your overall credit score, especially if the only type of debt you currently have is credit card debt.
Broadening your credit portfolio won’t improve your overall credit rating considerably, however. Credit mix only comprises about 10% of your credit score; increasing the types of debt you’re carrying may give you a modest boost, but it won’t significantly improve your standing in the eyes of the three credit bureaus. Additionally, if you’re already carrying multiple types of debt, a debt consolidation loan may do little to help diversify your credit and will likely have negligible effects on your overall credit mix.
Avoiding Red Flags
Most consumers strive to maintain a good credit rating because they want access to credit from banks when they need it for major purchases, such as a home, a car, or a luxury vacation. However, sometimes borrowers inadvertently hurt their chances of obtaining new credit by sending mixed signals to lenders with actions such as seeking debt consolidation loans. If your credit is average and you unsuccessfully apply for multiple debt consolidation loans, lenders later on may deem you too great a risk for a mortgage or automobile loan. This may be especially true if your debt consolidation applications are combined with other problematic credit activity, such as sporadic late payments.
If you want to preserve your credit and avoid the kinds of red flags that can scare off potential lenders in the near future, proceed carefully when it comes to debt consolidation. Don’t apply for any type of loan unless you’re reasonably sure you can gain approval. If you do get a loan, be careful to follow through with your debt reduction plan. Anything you do that can be considered erratic or in poor judgment such as late payments or delinquent accounts, or reckless and erratic credit utilization, could make banks less willing to work with you in the future. Think about your credit rating as your reputation, and then do everything you can to protect it in everything you do and every decision you make.
Another way that debt consolidation loans can affect your credit is by tying it all up while you’re paying off the loan and limiting your flexibility to make important life purchases. Many borrowers take out debt consolidation loans with long payback periods. Combined with low interest rates, this helps to reduce monthly debt payments and make them more manageable. However, as a result, they’re often saddled with a high level of outstanding debt for a much longer period.
While your monthly payments may be lower with a long-term loan, your ability to assume additional debt may also be limited. It isn’t likely that you’ll have the ability to take out additional loans for important life purchases. So, if you want to purchase a new car or your first home after you consolidate all your debts, you may have to wait until after that debt consolidation loan is paid off.
If you’re planning to make a major life purchase in the near future, you may want to choose debt consolidation options with shorter time horizons. A 0% APR balance transfer credit card, for example, may be a good choice for borrowers who have the desire and capacity to pay off all their debts in a year or so. Borrowers concerned about limiting their available credit may want to consider other options instead of debt consolidation to address their outstanding debts.
Debt Consolidation Limits
Debt consolidation may be a good option to consolidate your credit card and store credit debts. However, what about debts such as student, automobile, and medical loans? In some cases, those debts may be substantial and extremely difficult to consolidate. If you have significant debt that you cannot roll into the loan with your credit cards, there’s a chance that debt consolidation will only have a modest impact on your credit.
Borrowers with a high amount of varied debt will gain little in terms of credit mix or credit utilization if they chose to consolidate their credit cards. The new loan may help to streamline borrowers’ debt a little bit and make them less likely to miss a payment. However, they’ll still have a great deal of debt to contend with for a long period, and that’ll continue to weigh on their credit rating.
If you have high levels of debt that cannot be consolidated, it may make sense to choose options other than debt consolidation. In some cases, borrowers can deal with debt more effectively by selecting a debt management option better suited to their particular situation. For example, many lenders have programs available to help borrowers consolidate complex student loans.
In other cases, foregoing a new loan and developing a strategy to pay off all your debt methodically may make more sense. For example, for many borrowers, using techniques such as the debt snowball or the debt avalanche to focus on and systematically pay off debts may be a far superior option to debt consolidation. It may also be a better way to maintain a good credit score.
Interest Rate Traps
One of the ways that borrowers can inadvertently worsen their financial situations is by signing up for a debt consolidation loan and not paying attention to the terms and conditions. Many loans have variable interest rates, meaning the lender has the option to change the interest rate over the life of the loan. Unfortunately, that “change” is hardly ever in the form of a lower rate, and that subsequent rise can have a serious impact on a borrower’s ability to repay the loan.
A 0% APR balance transfer credit card is a perfect example of a variable rate debt consolidation loan. Borrowers transfer all their debt onto one of these cards with the intent of paying it off during the introductory rate period, usually 6-18 months. However, once that period ends, any remaining balance will be subjected to a much higher interest rate. Not only that but the fine print often states that the lender can retroactively collect all interest on the original balance if you didn’t pay it off by the end of the intro period. Many borrowers are then unable to cover the payments at the new rate, and they must either miss a payment or start using their previously paid off credit cards to keep up with their debt consolidation loan. Whatever option they choose, borrowers usually end up with a credit rating that’s worse than when they started.
You can avoid these situations by carefully reading a lender’s terms and conditions prior to taking out a debt consolidation loan. If you don’t believe you can pay off your debt before a loan’s introductory rate period expires, don’t select a variable rate loan to consolidate your debt. Instead, you should choose a fixed rate loan whose interest rate will remain the same throughout the life of the loan.
Did the Debt Consolidation Loan Fix What’s Broken?
You get a debt consolidation loan and use it to pay off all your credit card debt. Then, nine months later, you have the new loan and you yet again have high balances on those old credit cards you just paid off. Worse still, you’ve taken out new credit cards and store credit as well. Your credit utilization rate has risen substantially and driven your credit rating lower than ever. You’re starting to have trouble with all those debt payments again, too. Sadly, this scenario plays out more often than you think with debt consolidation loans.
Debt consolidation is just a tool to manage your outstanding debt more effectively; it cannot solve your financial problems. If you don’t address the underlying reasons why you ended up in debt in the first place, whether counterproductive spending habits, living beyond your means, or having no budget, you could end up in a worse situation than when you started, and with worse credit, too. All borrowers have to be prepared to change some financial habits when they decide to address all their outstanding debts.
A debt consolidation loan is a very bad option for any borrower who expects to have problems consistently making the payments. As noted earlier, becoming delinquent on debt accounts can do long-term damage to your credit. Additionally, if you have a secured debt consolidation loan such as a home equity line of credit, you can end up putting critical assets at risk.
Before you decide to take out a debt consolidation loan, you should talk to a trusted financial advisor. A trustworthy expert can analyze your debt situation and help you make the best decisions about how to deal with all your outstanding debts. A financial advisor can determine the best options for you to manage your debts without destroying your credit rating in the process.
Be Patient, and Always Consider Alternatives
A debt consolidation loan will definitely have an effect on your credit; all borrowers must determine whether that effect will be good or bad. If your debt consolidation loan helps you to manage your finances more effectively, maintain a budget, and make timely debt payments, it’s likely that your credit will improve over time. However, if debt consolidation only serves to worsen an already challenging financial situation, chances are strong that your credit rating will take a turn for the worse.
Prior to settling on debt consolidation, or choosing a particular type of loan, you should analyze your current situation and choose debt management options that’ll work best for you. This is an ideal time to bring in that trusted financial advisor. A good advisor will help you figure out how to address your debt and protect your credit at the same time.
Once you settle on a debt consolidation loan, make sure you tie it into a broader strategy to eliminate your debts and improve your financial situation. The loan should be linked to your budget and your spending plans, so you can make better financial decisions every day. Finally, even after consolidating your debts and beginning to repay them, don’t expect changes to your credit overnight. It takes a long time to pay down high levels of debt, and it may be months or even years before your debt reduction strategy begins to improve your credit rating significantly. Be patient and take a long view when it comes to improving your credit and paying off your debts.