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You may be considering debt consolidation if you've accumulated a significant amount of debt. However, you might not be taking action because you're worried about how debt consolidation will affect your credit score. While there is no one-size-fits-all answer to how debt consolidation will affect a person's credit, there are some general rules of thumb you can use to get an idea of how your credit score will be affected.
- How It Can Help Your Credit Score
- How It Can Hurt Your Credit Score
- When Does It Make Sense to Consolidate Debt?
How Debt Consolidation Can Help Your Credit Score
Your FICO credit score is calculated using the information on your credit report and a proprietary formula. The formula uses five main categories to calculate your score, but some are weighted more than others. The factors that influence your credit score the most are your payment history and how much of your available credit you're using. The factors that influence your score less include length of credit history, credit mix and new credit.
When consolidating debt, you'll reduce the number of payments you have to make each month, making your payments much easier to keep track of. If you've had trouble making payments on time in the past and consolidating your debt results in never missing a payment, your credit score could increase from this new positive behavior.
If you consolidate your credit card debt by taking out an installment loan, such as a personal loan, and pay off your credit cards, your credit score may improve after a few months. Paying off credit cards that are maxed out or nearly maxed out will help you lower your credit utilization ratio on revolving debt. This should help your score, but only if you leave the accounts open after paying them off and you don't run up a balance again. According to several lenders, borrowers may see their FICO score increase by about 20 points three months after consolidating their credit card debt using an installment loan.
Adding an installment loan to your credit mix can help your score if you've only had one type of credit account in the past, such as credit cards. Successfully managing multiple types of credit, such as installment loans, revolving debt and student loans, can show creditors you're a better financial risk. While credit mix isn't a large portion of your credit score, every little bit helps.
How Debt Consolidation Can Hurt Your Credit Score
Unfortunately, consolidating your debt won’t always result in a higher credit score. In fact, consolidating debt could result in a lower credit score in some cases. For instance, your score could drop if you transfer multiple credit card balances onto a single credit card and max out your new credit limit. Even though you'd only have one maxed-out card, a high utilization ratio is a red flag for creditors.
Regardless of how you consolidate your debt, making a couple of mistakes after the fact can lead to a lower credit score. First, you'll want to leave your old credit lines open to benefit from the lower credit utilization and credit history on the paid-off cards. You'll also want to avoid running up a balance on your freshly paid-off cards. If you can't pay off the balances in full, your credit utilization ratio may creep up again and hurt your score.
Taking out new credit, even if it's used to consolidate debt, usually results in a small decrease in your credit score due to the hard inquiry required to obtain the credit. Thankfully, "new credit" is one of the smallest portions of the credit score formula. A bigger mistake is missing a payment on your consolidation loan. This could lead to a larger decrease in your score, as payment history is the largest factor in determining your credit score.
When Does It Make Sense to Consolidate Debt?
Consolidating debt usually makes sense if it can help you achieve your goal—whether that's reducing the interest you pay or securing a lower monthly payment. It's important to remember that each situation is different. While aiming for a high credit score is a worthy goal, sometimes a lower credit score in the short term as a result of consolidating debt may be worth the sacrifice to save money on interest payments and pay off your debt faster.
That said, even if you can achieve your goal, you may want to hold off on consolidating your debt in certain situations. For example, if you think your score will decrease enough to impact the interest rate on an upcoming large purchase, such as a mortgage or a car loan, it may make more sense to consolidate your debt after your large purchase. Another reason to hold off on consolidation is if you know you don't have your financial life in order. If you know you'll run up credit card balances again after you consolidate the debt, you may want to wait until you have a better handle on your finances to avoid digging yourself into a deeper hole.