Does Debt Consolidation Hurt Your Credit Score?

Chloe Meltzer | December 02, 2022

Edited by Hannah Locklear

Debt consolidation is the act of bringing all of your debts together so that you can pay one monthly payment, rather than multiple. It is a method used when debts get out of hand. There are two main types of debt consolidation, a debt consolidation loan or a balance transfer card.

Both methods of consolidation are known to help with budgeting, and to lower your monthly payments. Eventually, the plan is that this will lead to paying off debt and raising your credit score. Despite this, it does not come without risks and may cause your credit score to go down at the beginning of your efforts.

Understanding debt consolidation

Debt consolidation is the act of combining multiple debts into one payment and with potentially lower interest. Not only does this help you to budget better for the future by knowing exactly what you owe, but having a lower interest rate can help to save you money. It also allows you to pay off the debt sooner because more of your money goes towards the actual amount you owe versus interest.

Because any type of credit application will trigger a hard inquiry on your credit report, your credit score may go down before it goes up. If you do notice that your credit score goes down by a few points for a few months, it is not a huge problem. If you practice debt consolidation properly, the overall effects will be positive. Namely, if you continue to pay on time and ensure that you do not stack up debt again.

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Types of debt consolidation

Personal loans

When using a personal loan to consolidate your debt you are essentially just obtaining a loan to pay off the original debts separately. The new payment will be reflected through your one personal loan payment. It is a simple method of having one payment to pay each month instead of multiple debts.

Personal loan debt consolidation is one of the best options for loan consolidation, and most people will qualify regardless of their credit score. It is actually a great option if you have less than stellar credit. It can also help you to improve your credit score, especially if you have never had a loan before.

There are a few downsides to this type of debt consolidation, if you aren't careful you might sign up for a high APR, and there might be a prepayment penalty. Be aware that after paying off your credit cards, you will have the opportunity to use up that newly freed space. This can eventually lead to more debt that you can't pay off. Additionally, if you miss payments on your new personal loan, it can greatly damage your credit score.

Balance transfer cards

Another option when you want to consolidate your debt is to do so with a balance transfer to a new card. This is essentially transferring the balance from one credit card to another. In doing so, you may be able to obtain a lower interest rate on the new card for a specific time. Some cards might offer 0% APR for a specific amount of time.

It is good to note that your score may initially fall because after a balance transfer, with the reason being “high credit utilization” if the limit on the new card is low. Additionally, you may also need to pay interest if you do not pay off your debt before the 0% APR period is over. Despite this, these payments are more flexible than with a loan, and there is typically no prepayment penalty.

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Home equity loans/lines of credit

Pulling out a home equity loan or line of credit is placing a loan on the equity that you own in your home. This will then be paid to you in cash. It is considered to be an installment loan or revolving account on your credit score, depending on how your loan is structured. In order to get this loan, you will need to go through a credit check which can negatively affect your credit for a short period of time.

Debt management plans

In some cases, seeing a credit counselor might be your best option. Credit counselors can help you to sign up for a plan to manage your debt. This is an alternative method but can give you tools and opportunities to do so. It is a good option if you are looking for something that does not affect your credit score, but instead, wish to negotiate the debt or close credit cards.

Use of a DMP is noted on your credit report while it is in effect, but not after the plan is completed. Debt management plans are placed on your credit report while you go through the process but will be taken off once you complete it.

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401(k) loans

Taking out a 401(k) loan means that you borrow money from your own retirement account. How much you are allowed to take out will depend on your employer, but in some cases, you can take out as much as 50% of your savings. Any of the interest that you pay on your loan will go back into your retirement account as well.

If you wish to avoid having any record of your debt consolidation on your credit report, a 401(k) loan might be your best option. This is because it will not affect your credit score. The only downside is that you may cost yourself investment returns. The longer you hold on to the loan the greater the effect will grow.

What to consider before debt consolidation

Debt consolidation can be extremely helpful if you are suffering from a lot of different debt at high interests rates. It is good to mention that it is not a good idea to replace unsecured debt with any type of secured debt. For example, replacing credit card debt with a mortgage or car loan. This could lead to losing your property versus only being in debt.

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>>Read the FastCompany article: Debt Lawsuits Are Complicated: This Website Makes Them Simpler To Navigate

>>Read the NPR story on SoloSuit: A Student Solution To Give Utah Debtors A Fighting Chance

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