Does Debt Consolidation Hurt Your Credit?

Debt consolidation is an option that borrowers consider when they have too many debts to deal with from credit cards to medical bills, personal loans and other types of payments. But does debt consolidation hurt your credit? That depends on how responsive you are to your repayment plan.

What’s ‌A‌ ‌Debt‌ ‌Consolidation‌ ‌Loan‌?

Debt consolidation or debt consolidation loans appeal to borrowers as they allow them to lump all of their loans from several places into one whole loan with a lower monthly payment and lower interest rate.

Furthermore, debt consolidation benefits consumers in that they stop making payments to many creditors in a month, and make only one payment to a single creditor every month. This is helpful as it reduces monetary stress, allows you to keep track of your payments and evidently makes repaying easier. If you keep this up, your credit score can also increase.

If you wish to consolidate your credit card loan by having your installment loan - like a personal loan - taken out to pay your credit cards off, you’ll notice that your credit score could improve in a couple of months. Paying maxed out or almost maxed out credit cards off can even reduce your credit utilization ratio on revolving debt.

How‌ ‌to Get Your Debt Consolidated

Here are a number of ways you can have your debt consolidated based on your savings and credit:

  • Personal loans: getting a personal loan with a lower interest rate allows you to pay off higher-interest credit card balances, enabling you to settle your debts much quicker. 
  • Balance transfer credit cards: These cards are another type of credit card that provides introductory periods when little to zero interest on balances - that you wish to transfer to your card in under a certain timeline - have been charged. This allows you to save interest and gives you a better opportunity to pay your debt off.
  • Home equity loan or line of credit: this is a great option for homeowners who have an ownership stake built up in their house. Through a home equity loan or line of credit, homeowners can take a loan out against their house, using it as collateral. The loans generally offer interest rates that are lower than personal loans or credit cards. But if they’re not paid in time, then there won’t be a home to own in the end.
  • Retirement account loans: this allows you to take out a loan from your retirement account to pay off or consolidate debt. Just be sure to pay it back before you end up facing severe penalties and taxes.
  • Life insurance loans: this is for paying off smaller debts. Consumers can borrow up to the policy’s cash value without being bothered much by repaying it. But if they don’t end up repaying, then they’ll lose their death benefits in the amount that was borrowed.

After hearing all of that, you can’t possibly assume that debt consolidation affects credit score, right? Well, guess what? It does and this is where we come to the other side of debt consolidation - the bad side.

How‌ ‌Your Credit‌ ‌Scores‌ Are Affected by Debt Consolidation

The sad reality about debt consolidation is that making a one-time payment for accumulated funds doesn’t always bring you a higher credit score. As a matter of fact, this could bring about a reduced credit score in some cases. For example, if you transfer all of your other credit card balances on one single credit card balance and then max it out, your score could drop. But even if you’re maxing out one card, having a high utilization ratio is not good for creditors.

Your credit utilization accounts for 30% of your credit score. If your debt-to-credit ratio is between 10% to 30%, it could positively impact your credit score. But if you max out your new credit card balance by lumping all of your other credit debts in one place, that ratio will be higher, severely damaging your credit score. So long as your debt consolidation payments are consistent and you haven’t made any new debts, this is a temporary drop in your score.

Even though debt consolidations provide relief from heavy debt load by offering lower interest rates and monthly payments, they are ironically, also at risk of forcing borrowers to pay more interest. Borrowers who utilize their home’s equity may be staring down at long loan terms and significant closing costs. What this means is that consumers may find themselves paying interest on their debt for over 30 years.

Another negative debt consolidation effect on your credit score is when consumers are too comfortable with the benefits of debt consolidation. This means that they no longer save and will spend as much as they please. If they are unable to change their habits from this behavior without budgeting their money, they will once again find themselves in heavy debt.

This site teaches you all you need to know about debt consolidation in Canada.

Bottom‌ ‌Line‌

So does debt consolidation hurt credit? There’s a yes and a no to this and it all depends on whether consumers are careful with how they repay their debts and ensure that they avoid the aforementioned consequences associated with debt consolidation. Other than that, debt consolidation can be a blessing in disguise if and when one knows how to make proper use of it.