Does debt consolidation hurt your credit? What you need to know

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Debt consolidation lets you roll several high-interests debts into one manageable payment. Find out whether it hurts your credit. (iStock)

If you want to lower — or simplify — your monthly debt payments, debt consolidation may be right for you. It can help you organize your finances and make it easier to pay off debt. With debt consolidation, you’ll combine all your debts into a single payment so you won’t have to worry about multiple payments, interest rates, and due dates. 

Just like any other financial strategy, debt consolidation isn’t for everyone. Here’s what you need to know about debt consolidation and its impact on your credit.

If you’re considering a personal loan to consolidate debt, Credible lets you compare personal loan rates from various lenders in minutes.

How does debt consolidation work?

With debt consolidation, you roll several debts into one manageable payment, ideally with a lower interest rate. It can help you simplify the debt repayment process and save on interest. A debt consolidation loan is a type of personal loan. 

If you’re overwhelmed with multiple debts, such as outstanding credit card balances, medical bills, or tax debt, then debt consolidation may be a great solution. You won’t have to keep track of different payments and interest rates, allowing you to pay off your debt with less confusion. 

Debt consolidation options

You can consolidate debt in a number of ways, including:

  • Personal loan — You can take out a personal loan with a lower interest rate than all or most of your other debts and use the funds to pay off what you owe. Many financial institutions — like banks, credit unions, and online lenders — offer debt consolidation loans.
  • Loan from friends and family — If you have a loved one with some extra cash, you may consider asking them for a loan at a low interest rate. You can use the funds to pay off your debts and pay back your family member or friend with one monthly payment. Just make sure the repayment plan is in writing so everyone is on the same page.
  • Balance transfer credit card — Once you open a balance transfer card, you move your current credit card debt onto it. In most cases, the balance transfer card will come with a promotional 0% APR. If you repay your debt in full during the promotional period, you can avoid interest charges. Otherwise, you’ll have to pay off the remaining balance at the card’s regular interest rate. You’ll generally need good to excellent credit to qualify for a 0% introductory APR.
  • Home equity loan or HELOC — A home equity loan or home equity line of credit (HELOC) allows you to borrow money that’s secured by your home. It can give you the cash you need to pay off high-interest debts at a lower interest rate. But if you fail to repay it, your lender can foreclose on your home.
  • Cash-out auto refinance — If you have equity in your vehicle, a cash-out auto refinance replaces your current car loan with a new, larger one — you can use the difference to pay off your debts. To be eligible for a cash-out auto refinance, your vehicle must be worth more than the remaining balance on your car loan.
  • Retirement loan — If you have a retirement account like a 401(k), you may withdraw money from it to consolidate debt. You’ll pay interest to yourself, and the loan payments will usually come out of your paycheck. Keep in mind that once you pull funds out of your retirement account, you’ll lose the power of compound interest on that amount. And, if you fail to repay the loan, you could face a tax bill on the amount you withdrew from the retirement account.

How debt consolidation can affect your credit

Debt consolidation can have both positive and negative effects on your credit. 

  • Hard inquiries can lower your credit score. When you apply for a balance transfer card or personal loan to consolidate debt, the lender will perform a hard inquiry on your credit. This can cause your credit score to take a temporary hit.
  • Your average credit age will decrease. As your credit accounts age and show a track record of on-time payments, your credit score will likely increase. By opening a new account, you’ll lower your average account age, which in turn could lower your credit score.
  • Your credit mix will become more diverse. Your credit mix refers to the types of accounts you have, like credit cards, loans, or a mortgage. Since lenders favor having a variety of accounts, opening a new credit card or personal loan may boost your credit score.
  • You’ll lower your credit utilization ratio. Your credit utilization ratio is the amount of revolving credit you’re using divided by the amount of revolving credit available to you. Since a new debt consolidation account can increase your available credit, it may lower your ratio and help your credit score.
  • On-time payments can improve your payment history. If you make timely payments on your new debt consolidation loan, your credit score will gradually improve. Payment history is the most important factor in determining your credit score, so be sure you never miss a payment.

When it makes sense to consolidate your debt

Debt consolidation isn’t for everyone, but it’s a great option if you’re currently struggling to keep up with monthly payments. If you’re able to get a lower interest rate than the rates on your current debts, you can save hundreds to thousands of dollars in interest over the life of your loan. Though if your repayment term is significantly longer, you may still end up paying more in interest overall. Consider these factors before consolidating your debt.

Debt consolidation may also be worthwhile if you know you can stick to your budget in the future. If you pay off your debts with a debt consolidation loan but immediately begin racking up credit card debt afterward, you’ll find yourself stuck in the same cycle all over again. 

Check out Credible to easily compare personal loan rates without affecting your credit.

How to get started

If you decide to move forward with debt consolidation, check your credit score first so that you know where you stand and what types of loans and credit cards you may qualify for. Then, make a list of all the debts you’d like to consolidate. 

Next, figure out which debt consolidation path you’d like to take. Shop around and compare all your options so you can find the best rates. After you’ve chosen the right path for your situation, be sure to make your payments on time. 

Alternatives to debt consolidation loans

If a debt consolidation loan isn’t right for you, there are other options you can turn to.

  • Create a budget — Sometimes, the easiest way to pay off debt is to create a budget and stick to it. You can choose from many different types of budgets to suit your needs.
  • DIY debt repayment strategies — You can use the debt snowball or the debt avalanche method to pay off debt on your own. While the debt snowball method focuses on paying off your smallest debts first, the debt avalanche strategy aims to help you save the most on interest by paying off your debt with the highest interest rate first.
  • Debt settlement — Debt settlement is when you negotiate with your creditors to settle for less than you owe. You can negotiate on your own or hire a professional debt settlement company to do so on your behalf. Be aware, though, that debt settlement may adversely affect your credit.
  • Debt management plans — Offered by credit counseling agencies, debt management plans are designed to help those with a lot of unsecured debt. A credit counselor will negotiate interest rates, monthly payments, or fees with your creditors. Once they do, you’ll make one payment to the credit counseling agency, who will use the money to pay your creditors. Debt management plans can also adversely affect your credit if you end up changing the terms of your agreements with creditors.

If you’ve decided to use a personal loan for debt consolidation, visit Credible to compare personal loan rates.