Does debt consolidation hurt your credit?

Paying off multiple debts at once is no fun. Consolidating them into one debt might not reduce what you owe, but it can help in other ways. Once you consolidate your debts, you’ll have fewer bills to manage each month — you might even be able to save money and get out of debt sooner.

Debt consolidation also generally won’t hurt your credit in the long run, and it may even help your scores grow. But it’s more difficult to say what the immediate impact will be on your scores because it depends on your current credit profile, the types of debt you have and how you consolidate the debt.

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What is debt consolidation?

Debt consolidation is the process of taking out a new loan or line of credit and using it to pay off multiple debts. Although you won’t decrease the amount you owe overall, consolidating your debts can be part of a helpful debt payoff strategy. And depending on your new loan or credit card terms, you might have a lower interest rate or monthly payment, which can save you money in the long run or give you more room in your budget today.

How debt consolidation affects your credit

“Paying off your debt doesn’t mean you have to close the account. Pay off your debt but keep the account open to maximize your credit score,” said Karl Jacob, CEO and founder of LoanSnap, a home loans company.

Debt consolidation affects your credit scores in different ways, some positive and others negative. The overall impact will depend on your current credit profile, but here’s a closer look at the impact on various credit scoring factors:

• Applying for new accounts can hurt your credit. Each loan or credit card application you submit could result in a hard inquiry — a record of when a creditor requests your credit report to make a lending decision. Hard inquiries aren’t a major scoring factor, but they can lower your credit scores by a few points.
• Opening new accounts may also hurt your credit. The average age of your credit accounts and the age of your newest and oldest credit accounts are also minor scoring factors. Older is better, so if you open a new account, it might hurt your credit scores.
• Adding to your credit mix might help your credit. Having open installment and revolving accounts could be good for your credit. If you only have credit cards, taking out a debt consolidation loan to consolidate the credit card debt could add to your credit mix and improve your scores.
• Changes in credit utilization might help your credit. Your credit utilization ratio measures the percentage of available credit you’re using on revolving credit accounts, such as credit cards. Your overall utilization ratio (from all of your accounts combined) and the ratio on each single credit card have a significant impact on your credit scores. If consolidation reduces your ratios or helps you pay off debt faster, your scores may improve.

Although there could be some immediate credit score changes, the goal of debt consolidation shouldn’t necessarily be to increase your credit scores. In the long run, as you make on-time payments and pay off your debts, your credit scores will improve. If debt consolidation can help you do this, and you can save money or better manage your budget in the process, then it may be a win-win.

Ways to consolidate debt

People generally consolidate their debts with a home equity loan or line of credit, a personal loan or a balance transfer credit card. There are pros and cons to each option that you’ll want to explore, including the associated risks, terms and fees. But here’s a brief look at how each one works.

Debt consolidation loan

Debt consolidation loans are generally unsecured personal loans. You can use the funds from these loans for almost anything, but creditors and personal finance websites use the term “debt consolidation loan” to appeal to consumers who want to consolidate their debt.

You can apply for personal loans through most banks, credit unions and some online-only lenders, and there are some options with low interest rates and no upfront fees. These loans tend to have fixed interest rates and repayment terms, so you’ll know exactly how much you’ll owe each month, how much you’ll pay overall and when you’ll pay off the loan.

However, because the loan is unsecured, your rates and terms will largely depend on your creditworthiness. If you don’t have good credit, you might only qualify for a small loan, high interest rate or have to pay an origination fee — an upfront fee that’s taken out of your loan funds.

Home equity loan or line of credit

If you have equity in your home, you might be able to get a home equity loan (HEL) or home equity line of credit (HELOC). The amount you’re approved for will depend on factors such as how much equity you have, but these products tend to have low interest rates because you use your home as collateral.

However, using your home equity to consolidate unsecured debt, such as credit card debt, opens you up to the risk of losing your home. If you fall behind on unsecured debts, you might hurt your credit, have to deal with collectors and as a worst-case scenario, the creditor could sue you and try to garnish your paycheck or bank account. But if you fall behind on a HEL or HELOC, the creditor can foreclose on your home.

Balance transfer credit card

Balance transfer credit cards are credit cards that offer a 0% annual percentage rate (APR) on balance transfers during a promotional period. Offers vary, but the promotional period might last around 18 to 21 months with some of the best cards.

You can transfer debt onto the balance transfer card and then pay down the balance while it’s not accruing interest. You might be able to “transfer” a balance to your bank account and use those funds to pay down other types of debt, like a medical bill or auto loan as well. However, you generally can’t move balances between cards from the same credit card company.

The 0% APR can help you save money, which you can use to pay down the debt faster or put toward other expenses, but there’s often a balance transfer fee of 3% to 5% of the amount being transferred. Consider how much you’ll pay in fees versus how much you might save in interest to see if the balance transfer makes sense. Also, review the terms closely. You might need to transfer balances within the first few months to receive the 0% APR offer.

Is it bad to apply for multiple credit cards at the same time? Here’s what you need to know.

Other ways to consolidate debt

There are other ways to consolidate debt, such as taking out a 401(k) loan or borrowing money from friends or family. As with any type of loan, there are pluses and minuses to consider.

With a 401(k) loan, you may have to pay a 10% tax on the amount you borrow, plus income taxes, if you don’t repay the loan on time. Also, if you lose your job, you may have to pay the full balance by the next tax filing deadline. On top of that, you lose out on some of the compound interest you would have accrued before retiring.

Like a 401(k) loan, a loan from a family member won’t be reported to the credit bureaus, which means it won’t directly affect your credit. And your credit scores might increase as a result, if it helps you pay down your debts. But you put your personal relationship at risk if you can’t pay off the new loan.

Alternatives to debt consolidation loans

You might not want to take out a new loan or line of credit to consolidate your debts. Or, you might not qualify for a new account with a large enough limit or low enough interest rate. In either case, there are a few alternatives worth considering:

• Use a debt payoff strategy: You could try to increase your savings or income and use the extra money to take a focused approach to paying down balances. The debt snowball and debt avalanche strategies are popular options that involve focusing on the debt with the lowest balance or highest interest rate first, which can help you stay motivated or save money.
• A debt management plan: A nonprofit credit counseling organization might be able to help you set up a debt management plan (DMP). These plans can consolidate credit card debt so you pay the counseling agency each month, and the agency then pays your creditors. There may be an upfront and monthly fee for the DMP. However, the credit counselor can try to negotiate with your credit card companies to lower your interest rates and waive accrued fees. The end result is often a lower overall monthly payment, interest savings, lower total cost and paying off the credit cards within three to five years. However, you may not be able to open or use any credit cards while you’re on a DMP.
• Filing for bankruptcy: Bankruptcy can hurt your credit for years. However, it might make sense if you’re completely overwhelmed with debt and can’t find a way to pay off all your bills. With a Chapter 13 bankruptcy, you get on a structured repayment plan for your unsecured debt and you might be able to keep most of your possessions. At the end of the plan, often three to five years, the remaining debt is forgiven.

Is debt consolidation a good idea?

Consolidating debt might help you save money or free up room in your budget, and some options can give you a structured repayment plan with a concrete debt-free date in the future. But you also need to consider why you’re in debt in the first place.

Many people struggle with overspending on credit cards, and using a debt consolidation loan (or other option) to pay off those balances doesn’t address the core issue. You might wind up worse off if you take out a new loan and then max out your credit cards again. On the other hand, if you have loans or credit card debt from an emergency or temporary setback, then consolidating that debt might make sense.

Frequently asked questions (FAQs)