Paying down debt can help improve your credit score, but some debt consolidation measures can have some potentially negative effects. (iStock)
Debt consolidation is the process of replacing one or more loans or credit cards with a new one. In the right situation, consolidating your debts can simplify your repayment plan and even save you time and money, if you can qualify for a lower interest rate.
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There are several tools you can use to consolidate debt, including personal loans, home equity lines and lines of credit, balance transfer credit cards and debt management plans. Regardless of which option you choose, it’s important to understand how they can influence your credit score for better or worse.
Applying for new credit
The first way most debt consolidation options can affect your credit score is through the credit inquiry that occurs when you apply for a loan or credit card. For most people, these hard inquiries knock fewer than five points off your credit score, according to FICO.
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Each inquiry remains on your credit reports for two years, but they’ll only impact your FICO credit score for one year.
Shifting a credit card balance
If you’re consolidating a credit card balance, how you do it can impact your credit utilization rate, which is a significant factor in your credit score.
This figure is calculated by dividing your card balance by its credit limit, so a $1,000 balance on a card with a $2,000 limit has a 50 percent utilization rate—credit experts recommend keeping your rate below 30 percent. The ratio is calculated for each individual card and across all of your cards.
If you consolidate your credit card debt with a personal loan, it’ll wipe out your credit card balance and result in a 0 percent credit utilization rate. If your rate was high before the consolidation, your credit score may improve dramatically.
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If you get a new credit card and balance transfer offer—many cards offer an introductory 0 percent APR for several months—your utilization rate will be recalculated based on the balance you transferred as it relates to the new card’s credit limit. If the transaction increases your utilization rate, it could hurt your credit. But if it reduces the rate, it could have a positive impact.
And, of course, as you pay down your credit card balance, your utilization rate will go, which could cause your credit score to go up.
Debt management plan
Getting approved for a personal loan with a low-interest rate or a balance transfer credit card typically requires good credit, which starts at a FICO score of 670. If your score isn’t in good enough shape, you may be able to get on a debt management plan with a credit counseling agency.
With this plan, the credit counselor acts as an adviser to help you improve your money management skills. They’ll also handle payments to all of your creditors—you make one monthly payment to the agency, and it splits it up and pays your lenders directly.
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Debt management plans won’t affect your credit directly. But sometimes, you may be required to close your credit cards to start a plan, which can affect your length of credit history and, therefore, your credit score.
Also, if you’re past-due on some payments, some credit counselors may be able to convince your creditors to “re-age” your account, updating its payment status to current. This process can have a significant positive impact on your credit score.
Is debt consolidation right for you?
Debt consolidation can affect your credit score both positively and negatively, but it’s important also to consider other benefits. For example, transferring a credit card balance could temporarily increase your utilization rate, but the interest savings from a 0 percent APR promotion could have a more lasting positive impact on your overall financial health.
Consider your situation and your options carefully, and pick the one that’s best suited to your needs. And whatever you do, remember that debt consolidation is just a means to an end: becoming debt-free.
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February 04, 2020 at 10:29PM
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How does debt consolidation affect your credit score? - Fox Business
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