Does Debt Consolidation Hurt Your Credit Score?

If your credit card bills are stacking up, you aren’t alone. According to the Fed, credit card balances are up in 2022, thanks in part to inflation. To make matters worse, interest rates are also on the upswing. Multiple bills and rising card balances can make it difficult to get debt under control. Using a relatively low-interest personal loan to pay down high-interest credit card balances and medical debt could save you money on interest and simplify your life. But what does this strategy, known as debt consolidation, do to your credit score?

Ideally, debt consolidation should help your credit—at least over the long term. A lower interest rate and a single fixed monthly payment could make your debt easier to pay down. Lower credit card balances and on-time payments on the loan can raise your credit score. Debt consolidation isn’t foolproof, however. Your credit score may dip temporarily right after you get your loan. And you’ll have to avoid running up new credit card balances.

Exactly how does debt consolidation affect your credit score? Read on to learn more.

What Is Debt Consolidation?

Debt consolidation means refinancing your existing loans, debt, and credit card balances into a single loan. This could mean taking out a home equity loan, using a zero-interest credit card balance transfer offer, or finding a lower-interest personal loan that will cover your outstanding debts.

By using a personal loan to pay down your higher-interest loans and credit card balances, you can effectively replace several monthly bills with one. And since a personal loan usually has a fixed interest rate and regular monthly payments, your monthly expenses are easier to plan for. A personal loan also has a fixed term: One to five years is typical. At the end of your term, your debt is repaid.

How Can Debt Consolidation Help Your Credit?

A debt consolidation loan primarily helps your credit by making your debt easier to pay down. The building blocks of good credit are consistent on-time payments and low to moderate credit utilization. Using a personal loan to replace multiple credit card bills can help with these:

• Make a single loan payment instead of many.
  If you have multiple credit cards, tracking their monthly due dates can be a challenge, so replacing them with a single personal-loan payment can make it easier to stay on-time with your bills.

• Convert to a fixed monthly payment and interest rate.
  Interest rates on your credit cards can change periodically (and in today’s climate, rate changes tend to be increases). And if you’re carrying a balance, credit card bills’ minimum payments change monthly, as well. Replacing multiple credit card bills with a personal loan that has a fixed interest rate and a set monthly payment can save you money and simplify budgeting.

• Lower your costs with a lower interest rate.
  Interest rates on credit cards are usually higher than those on personal loans, so lower finance charges on a personal loan will typically save you money, leaving you with more cash to pay your bills (or sock away as savings).

How does simplifying your monthly payments and saving money on interest help improve your credit?

• Payment history is the single biggest factor in determining your credit score.
  Making timely payments may account for 35% to more than 40% of your score. Consolidating debt doesn’t guarantee on-time payments, but it may decrease your chances of overlooking a payment or forgetting to set aside enough money to pay it.

• Converting card balances to an installment loan may improve your credit utilization.
  Credit utilization is the percentage of available credit you’re using by carrying credit card balances. If you roll your card balances into a debt consolidation loan, credit utilization on your credit cards drops to zero. Credit utilization greater than about 30% can hurt your credit scores; utilization below 10% is ideal for score improvement.

• Adding an installment loan could improve your credit mix.
  Credit scores tend to benefit from a mix of credit accounts: credit cards, home loans, auto loans, and so on. Adding an installment loan could add to your credit mix and give your credit score a small lift. Having a range of loans and credit shows that you know how to manage different types of accounts.

Paying down significant debt reflects well on your credit overall. By lowering your interest costs, streamlining monthly bills, and paying down what you owe, debt consolidation may help you raise and maintain your credit score.

How Can Debt Consolidation Hurt Your Credit?

For all its potential positives, debt consolidation can have a few negative effects on your credit, especially when you first get a loan. These effects should be minor and can be offset when you establish a record of repaying your new loan on time. Here are a few to bear in mind:

• A hard inquiry on your credit report may ding your credit score.
  During the loan application process, your lender will check your credit report, a process known as a “hard pull” or “hard inquiry.” Hard inquiries appear on your credit reports and can cause a minor drop in credit score.

• Credit inquiries aren’t a huge blow to your credit.
  Their effect is small, and it diminishes over time. Inquiries made within a few weeks of each other may also be grouped into a single event. Still, avoiding hard credit inquiries until you’re ready to apply can help you limit the damage further.

• Adding a new loan decreases the average age of your accounts.
  The average age of your credit and loan accounts is a measure of how long you’ve been managing debt. Long-standing accounts have a positive effect on your credit score. When you get a new loan, the average age of your accounts goes down, which can cause a dip in your credit score.

• Closing your old accounts creates more complications.
  If you can, keep credit card accounts open after you’ve paid off your balances. You’ll maintain the longevity of your accounts. You’ll also keep your total amount of available credit high, so your total credit utilization ratio isn’t thrown out of whack. If your total amount of available credit drops, the utilization represented by any outstanding balances on other accounts increases.

5 Ways to Keep Your Debt Consolidation Credit-Friendly

Maintaining good credit is a good reason to consider debt consolidation. You can improve your chances of success—and minimize any negative effects—by following a few guidelines:

1. Check your credit before you shop.

See what’s in your credit file before you start applying for loans. You can check your credit report from all three major credit reporting agencies—Equifax, Experian, and TransUnion—for free at AnnualCreditReport.com. Make note of late payments and other negative information and dispute any errors you find. A credit score may also be available for free from one of the credit bureaus—or check with your credit card company to see if they provide it.

Better loan rates and terms are generally available to individuals with higher credit scores. Knowing your credit score and what’s in your credit report can help you compare rates on loans that fit your credit profile.

2. Limit hard credit inquiries by using pre-qualifications.

Many lenders can pre-qualify you for a loan without doing a “hard” credit pull that affects your credit score. Pre-qualifications give lenders a quick read on your credit and financials so they can quote loan rates and terms more accurately. Once you decide on a loan option, your lender will do a hard credit pull to approve your loan.

3. Think carefully about loan terms.

Consider your monthly payments and loan term. Will you be able to meet your monthly payments on time every month? Should you extend your loan term to lower your payment—or shorten it to pay your debt down sooner? Before you sign on to a new loan, make sure it’s going to make managing your debt load easier.

4. Make your payments on time, every time.

Your good payment history will boost your credit score as you go. You may want to consider automatic payments, to avoid accidental late payments. Try to stay out of delinquency: One 30-day late payment may haunt your credit report and lower your credit score for as long as seven years or more.

5. Avoid running up new debt.

Once you have a debt consolidation loan in place and are paying down your debt, try to avoid building up new balances on your credit cards. You may find yourself with multiple monthly bills and high credit utilization again. Once you get on track with your debt and credit, stay there.

The Bottom Line

Debt consolidation can help you simplify multiple debts, save you money on interest, and even help keep your credit on track. If you’re dealing with high-interest credit card balances, multiple loans, medical bills, or other debt, you may want to look into how debt consolidation could change your monthly finances—and put an end point on paying off your obligations.

If debt consolidation is a smart idea for you, acting soon, before managing your current debt load becomes unmanageable, might ultimately be good for your credit. You’ll have an easier time finding a loan with a great rate and terms if your credit is still in good shape, and not damaged by late payments or over-utilization. You’ll position yourself for continued success with a loan that’s easier to track and easier to pay over the long term. Making your loan payments on time will help you overcome any temporary dip you might see as a result of getting a new loan.

Fewer bills and a solid plan for paying down debt don’t affect your credit directly. But under the right circumstances they can help you maintain the habits that build good credit—and avoid a few of the pitfalls that can lead to credit problems.