Do Consolidation Loans Hurt Your Credit Score? Get the Facts

Estimated read time: 6 minutes

If you're in debt over your head, it could feel like you'll never get out. You may have even considered options like debt settlement and bankruptcy. Before you do that, you should think about a debt consolidation loan. In short, debt consolidation loans are those that offer a significant amount of money to consumers at a lower interest rate than your credit cards, making it beneficial to refinance debt and change your situation before you approach other less favorable options. Here are the ins and outs of debt consolidation loans and your credit score:

What is a Debt Consolidation Loan?

There are two types of debt consolidation: debt settlement and loans. We discussed debt consolidation in terms of debt settlement in a previous blog post. In this article, when we refer to debt consolidation, we are referring to loans that help consumers package their debt into one monthly installment payment at a lower interest rate.

The benefits of taking out such a loan are immediate and obvious:

  1. You pay off high interest credit debt.
  2. You decrease your credit utilization ratio.
  3. You walk away with one monthly payment that replaces multiple.
  4. You make a lower payment each month when you consolidate with a lower interest loan.

Types of Debt Consolidation Loans

There are several types of ways that people can consolidate debt. Common sources of debt consolidation include: balance transfer credit cards, home equity loans, personal loans, and debt consolidation loans. We'll look at each below:

Balance Transfer Credit Cards

While not technically a loan, a balance transfer credit card can be a good way to refinance debt. When you get a balance transfer card, you are approved for a credit card with lower interest that will accept your current credit balance, usually for a small fee. For most people seeking major debt consolidation, this approach has some limitations:

First, a balance transfer credit card isn't likely help those who are deep into debt. If you have $20,000 or more in credit card debt to consolidate, it will be difficult to qualify with a card that has a limit to support that whopping load of debt. At best, you can expect to partially refinance your balance, but that doesn't help your situation as a whole and doesn't reduce your payment down to one monthly installment. If you are in this situation because you have trouble with responsible credit spending, getting access to a new credit line may not be in your best interest either.

That said, if you're worried about a debt that's under $10,000, a debt consolidation loan might be a little pre-emptive. It's easy enough to qualify for a good balance transfer card, and that would likely be your quickest and most effective way to pay down debt. Just make sure you can use it responsibly! If that's not something you can hold yourself too, it may be worth looking into a more traditional loan, anyway.

Home Equity Loan

If you own a home that has accrued equity, a home equity loan might be the best path to clearing credit card debt. Accessing the equity in your home through a home equity line of credit allows you to pay off multiple high balance credit cards effectively financing them with a similar interest rate to a traditional mortgage. This results in one manageable monthly payment and a faster, more effective plan to pay down debt.

However, like a traditional mortgage, a home equity loan can be a challenge to get. If you think back to what the underwriting process was like when you bought your home, you may remember agonizing over your debt-to-income ratio, providing necessary documents to substantiate your claims of income, and maybe even having to recruit a co-signer to seal the deal.

Taking out a home equity loan is similar to taking out a second mortgage, the underwriters will put you through the financial ringer. If you come out on top, the interest rate is usually excellent and the life of the loans can span around 30 years, making the monthly payments more affordable.

Personal Loans

In general, a personal loan is similar to a home equity loan, however, interest on a personal loan can vary wildly. To ensure you're getting the best from a personal loan intended to pay off debt, ask yourself a couple of questions:

  1. Will this loan cover the full balance of my credit card debt?
  2. Is the interest rate on this loan lower than the interest rate on my lowest credit card?

Ultimately, you want to make sure that by refinancing your payments are going to be more manageable and your debt can be paid down with ease. If you're making the minimum payments on high interest credit cards, you likely aren't moving the needle on those balances at all. If you get the right personal loan, you can pay debt faster and more effectively, but since the terms can vary so much it's important to have a specific vision of what your needs are going into the agreement.

One downside of taking out a personal loan is that it could be near impossible to qualify, especially without a cosigner, depending what shape your credit is in. Home equity loans are backed by the value of your house, whereas personal loans aren't. That means the bank takes more risks when issuing a personal loan and may require that you take extra steps, like offering collateral, if you qualify at all.

Collateral is the difference between a secured and unsecured personal loan, the former requires it and the latter does not. If you're seeking an unsecured personal loan, you'll may want to take steps to repair your credit as much as possible before applying.

Another consideration is that personal loans can have payment schedules that aren't intuitive, sometimes requiring installments two or three times a month, depending on the type and size of the loan. Make sure you understand the terms of any loan you take out and ask questions of your financial institution to ensure you're getting the best deal.

Debt Consolidation Loan

A debt consolidation loan is basically a personal loan that's designed for the soul purpose of consolidating debt. These are usually issued by financial institutions geared at indebted consumers and have varying terms and conditions. By design, these loans usually have a lower interest rate than your credit card debt and offer an easy installment plan, developed to reduce the overall burden of your credit card debt.

Debt Consolidation: When and Why it Hurts

If you're still considering your debt consolidation options, let's look at how they impact your credit score:

Debt Settlement

While this article is not specifically about debt settlement, it is a valid form of debt consolidation for those without more favorable options. When debt settlement is used to consolidate a debt, a person or company, usually a third-party debt consolidation agency, is responsible for negotiating on your behalf.

During these negotiations, sometimes consumers feel pressure to stop talking with their creditors, and what's worse, they stop paying them the minimums, too. It's not advisable to stop paying your creditors for any reason. If you're lucky, the result is a scar on your credit score that can take a long time to repair and a reduction in overall debt burden. If you're not lucky, you can end up on the wrong side of a lawsuit. For these reasons, getting a debt consolidation loan is a better choice than debt settlement.

Closing Accounts

If you've received a debt consolidation loan, and used it to pay down credit card debt before closing your accounts, you may think you're doing things on the up and up, but that can hurt your score. It's always advisable to leave your credit accounts open and avoid spending on them. This gives you a better credit utilization ratio which is a big part of how your credit score is adjusted.

Hard Credit Pull

Whenever you get a loan, the financer does a hard credit pull. It's common knowledge that credit pulls are a necessary evil the puts a ding on your credit score.

Help Your Credit Score with Debt Consolidation

As mentioned above, there are a few ways debt consolidation can hurt your credit score, however, the long-term impact of consolidating debt with a loan is sure to set your credit score straight. Here's why:

Credit Utilization Improves

Debt consolidation improves your credit utilization when you use a loan to pay off your credit card debts, and leave the accounts open.

Easier Payment Schedule

By selecting the right installment loan, you can get out of debt faster, improving your score, making only one monthly payment in most cases. This eliminates the possibility of mismanaging your calendar, and making late credit card payments that hurt your score. When it comes down to it, if you play your hand just right, getting a debt consolidation loan helps your credit score and eases the burden of high-interest credit debt.

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