But even our best debt consolidation loans have a direct impact on your credit score. Whether it raises or lowers your credit score depends on the chosen consolidation method, the types of debts, and your credit management habits during repayment.
This article will guide you through how debt consolidation affects your credit and help you make an informed decision for your financial future.
Key Insights
Debt consolidation can have a positive or negative impact on your credit score.
How debt consolidation affects your credit score depends on factors that include the debt consolidation method, the types of debts you have, and more.
In the long run, making your debt payments on time and reducing your debts can help you improve your credit score.
How Debt Consolidation Can Raise Your Credit Score
Establishes Positive Payment History
Payment history affects your credit score more than any other factor. Credit scoring models primarily evaluate whether you consistently make payments on time or have delinquencies on your record. Any payment that's 30 days or more overdue can be reported to credit bureaus and lower your credit score.
Debt consolidation simplifies your financial obligations by combining multiple debts into a single monthly payment. This makes tracking and managing your payments considerably easier.
Plus, consolidation often results in lower monthly payments, helping you stay within your budget and avoid missed payments. With consistent, on-time payments, you can gradually rebuild credit by establishing a positive payment history.
Lowers Your Credit Utilization
- Credit utilization ratio matters: Credit utilization significantly impacts your credit score. Scoring models evaluate how much of your credit limit you're currently using on revolving accounts like credit cards or HELOCs.
- Consolidation zeros out balances: Using a consolidation loan to pay off revolving credit accounts immediately reduces your utilization to zero on those accounts. Keep those accounts open afterward—closing them could actually increase your utilization ratio.
- Stay below 30% utilization: Financial experts typically recommend keeping utilization below 30% of your available credit for optimal score improvement.
"The quickest and most impactful way to boost your credit score is by lowering your credit utilization rate. When you consolidate multiple high-interest credit card debts into one loan, you're often reducing that rate.
Credit utilization—the percentage of your available credit that you're using—accounts for 30% of your total credit score," says Hillary Seiler, personal finance expert and president/founder of Financial Footwork.
"While the improvement may not be instant, typically taking 30-120 days depending on your credit situation, it almost always has a positive effect in the long run."
Diversifies Your Credit Mix
Credit scoring models look at the types of credit you have:
Installment accounts: These tend to have fixed monthly payments, fixed interest rates, and predetermined loan terms. Think mortgages, auto loans, student loans, or personal loans.
Revolving accounts: These accounts have an available line of credit to borrow from, with variable interest rates and fluctuating monthly payments. Think credit cards or HELOCs.
Pro tip: Having both types of credit accounts can positively benefit your credit score. If consolidating your debt adds another type of credit into the mix, your score could see a boost.
For example, combining your credit card balances into a personal loan adds an installment account to your credit report. This diversity is especially beneficial if you previously only had revolving accounts.
How Debt Consolidation Can Lower Your Credit Score
Debt consolidation can also hurt your credit score in a few ways. Here's what you need to know:
Adds Hard Inquiries to Your Credit Report
When you apply for a consolidation loan or credit card, lenders will check your credit history. This creates a "hard inquiry" on your credit report. Each inquiry can temporarily drop your score by a few points.
The effect is more noticeable if you've recently applied for several other credit products. However, these impacts typically fade within a year if you maintain on-time payments.
"When you apply for a debt consolidation loan or a balance transfer card, lenders are going to do a hard pull on your credit. Each of those inquiries can knock your score down a few points. Don't worry, though, this is usually temporary," says Seiler.
Lowers the Age of Your Accounts
Your credit history's length matters to your score. Credit bureaus look at both individual account ages and the average age across all your accounts. Longer histories typically boost your score.
When you open a new consolidation loan or credit card, you reduce your average account age. This can temporarily lower your score, especially if you don't have many established accounts.
"Opening up a new credit account to consolidate your debt lowers the average age of your credit accounts. Since your credit history makes up 15% of your FICO score, this could ding your score and drop it a bit. It will rebound over time, but be prepared to see that initial drop," says Seiler.
Raises Credit Utilization
Sometimes, consolidation can increase your credit utilization ratio. This happens most often when you use a credit card or HELOC to consolidate. If your new balance takes up a high percentage of your available credit limit, your score could drop. Remember that higher utilization generally means lower scores.
Late Payments With Debt Settlement Companies
If you work with a debt settlement company to negotiate lower debt payoff amounts with your creditors, the company will advise you to stop making payments on the debts you wish to consolidate.
This can give these companies some bargaining power to get creditors to negotiate, but in the meantime, your credit could take major damage with late payments and even accounts in collections.
Best Ways to Consolidate Debt
1. Credit Card Balance Transfers
When you mainly need to consolidate credit card debts, a credit card balance transfer can help you:
- Save money through promotional 0% APR periods
- Combine multiple debts onto a single card with one monthly payment
This option works best when you can pay off the transferred balances before the promotional period ends, avoiding the regular interest rate.
"If your credit's solid, transferring high-interest debt to a 0% APR balance transfer card can save you big on interest and give you time to pay it down. Just make sure to pay it off before the intro period ends, or you'll face high interest.
Keep in mind, applying for a new card means a hard inquiry, which could slightly lower your score temporarily," says Seiler.
2. Personal Loan
Personal loans (often called debt consolidation loans) provide a straightforward solution:
- You borrow money from a bank or lender to pay off your creditors
- Many lenders will even pay your creditors directly
- You repay the loan over a set term, typically 2-5 years
The main advantages include potentially lower interest rates than your current debts and predictable, fixed monthly payments.
3. Home Equity Loan or Home Equity Line of Credit
When you own your home with significant equity, you can leverage that value:
- Home equity loans: Borrow a one-time lump sum to pay off creditors, then repay over a fixed period.
- HELOCs: Get a line of credit up to your available equity amount, withdraw as needed, and make a single monthly payment.
Remember that these options put your home at risk. If you fail to make payments, you could face foreclosure.
4. Debt Settlement Company
Working with a debt settlement company involves:
- The company negotiates with creditors to accept lower payoff amounts.
- You make monthly payments to the company, which distributes funds to creditors.
- Your total debt amount may be significantly reduced.
Downsides to consider:
- Companies often charge fees up to 25% of settled debt amounts.
- They typically instruct you to stop making payments during negotiations.
- Your credit score can suffer major damage from missed payments.
5. Debt Management Plans (DMPs)
Credit counseling agencies offer debt management plans that can help you:
- Negotiate better terms with creditors (especially lower interest rates).
- Make a single monthly payment to the agency.
- Have the agency distribute payments to all your creditors.
Pro tip: DMPs generally cost less than debt settlement services, but don't reduce your principal debt amount—just the interest and fees.
Bottom Line
Debt consolidation can both help and hurt your credit score, depending on how you use it. While new credit inquiries and accounts may temporarily lower your score, the benefits of simplified payments, lower interest rates, and improved payment history often lead to better credit in the long run.
Choose your consolidation method wisely and stay consistent with payments to see the best results.
Frequently Asked Questions
How much does debt consolidation affect your credit score?
The degree to which debt consolidation affects your credit score depends on several factors, including the debts you consolidate, the debt consolidation method you use, the current state of your credit score, and more.
How long does debt consolidation stay on your record?
New credit accounts opened for consolidation remain on your credit report while active and for seven years after closing. Any debts you pay off through consolidation also stay on your report for seven years after they're closed.
Why should you consolidate your debt?
Consolidating your debt can help you streamline your monthly payments, making them easier to track, and could even reduce your monthly payment. You can even save money in the long run if you can access a lower interest rate than you were previously paying on the debts you consolidated.
