Does debt consolidation help your credit score?

Debt consolidation is the process of combining multiple owed balances into one account. You can do this through a credit card balance transfer, personal loan, or line of credit, making your debt more manageable and even saving money by reducing interest costs.

But debt consolidation can also affect your credit. Here’s a look at how it can help your credit, how it can potentially hurt your credit score, and some different ways to consolidate debt.

• How debt consolidation can help your credit
• How debt consolidation can hurt your credit
• What makes up your credit score?
• How to build your credit score after taking out a debt consolidation loan
• Personal loan vs. balance transfer card: Which should you pick?
• Other ways to consolidate debt
• Why taking out a debt consolidation loan can save you money

How debt consolidation can help your credit

A debt consolidation loan can help you build or improve your credit score in a few ways:

• It can lead to a faster payoff. When you consolidate your debt into one account, you may be able to lower your interest rate or monthly payments. This could allow you to pay off more of your balance each month than when you were juggling multiple accounts, getting you out of debt sooner. And the sooner you reduce your balance, the better your credit score will be.
• It can reduce your credit utilization. Your credit utilization ratio is how much credit you’re using compared to how much available credit you have. By shifting your debt from, say, a maxed-out credit card to a new line of credit, you’ll reduce your credit utilization for that account. Depending on how much of your credit limit was available previously, your score could go up.
• It can boost your credit mix or payment history. If you only have credit cards on your credit report, adding a personal loan account could add to your credit mix, which can bump up your score as you make on-time payments.

How debt consolidation can hurt your credit

Streamlining your debt comes with many financial benefits. But debt consolidation can also hurt your credit in a few ways:

• Hard credit pulls may reduce your score. Lenders will make a hard inquiry when considering your application for a new loan or credit-based product. This can temporarily lower your credit score by a few points. The more hard inquiries you have in a short period of time, the more you can expect your score to drop.
• New credit affects the average age of your accounts. If you’re taking out a new loan or line of credit to consolidate your existing debt, this will lower the average age of your credit accounts, which can also cause your score to drop.
• It can affect your total available credit. If you transfer multiple balances to a new type of credit — a balance transfer card, for example — and then cancel the paid-off cards, that reduces the total amount of credit you have available. This can negatively affect your credit utilization ratio.

Thankfully, the effects of debt consolidation are generally short-term in nature. By making your new loan payments on time and chipping away at what you owe, any temporary shift in your credit score will usually begin to correct itself in a few months.

What makes up your credit score?

Technically, you have many different credit scores, depending on which scoring model a lender uses. The most commonly used scoring model is FICO, provided by the Fair Isaac Corporation.

FICO takes these factors into account when calculating your score:

• Payment history (35%) — Your payment history is the most important factor that determines your credit score. A history of on-time payments shows lenders that you’re more likely to repay a loan.
• Amount owed (30%) — This is how much total credit you owe compared to your available credit.
• Average age of accounts (15%) — This includes how long you’ve been managing your credit-based accounts, how old your oldest account is, the age of your newest account, and how long it’s been since you used certain accounts.
• New lines of credit (10%) — Lenders also consider accounts with a short history and recent inquiries for new credit.
• Credit mix (10%) — Your credit mix is the different types of credit-based accounts you have and manage, such as auto loans, credit cards, and student loans.

How to build your credit score after taking out a debt consolidation loan

If you take out a debt consolidation loan, here are some things you can do to build your credit score:

• Make payments on time, every time. A debt consolidation loan can help you build a strong credit history, but only if you make your monthly payments on time and in full.
• Create a budget. Your budget should account for your new loan payment and other monthly bills, and you can also use it to help prevent overspending.
• Avoid creating new credit card debt. Once you’ve paid off your credit card balances, it’s important to limit (or even avoid) making additional credit card purchases, especially if your budget won’t allow you to pay the statement balance in full each month.

Personal loan vs. balance transfer credit card: Which should you pick?

Taking out a personal loan and transferring balances to an existing credit card account are both popular options for consolidating debt. But which is the better choice?

The answer really comes down to how much you owe, your available credit, and what interest rate you qualify for. For example, if you have multiple accounts and higher balances, taking out a $20,000 personal loan may be more cost-effective than transferring six different balances and paying credit card balance transfer fees each time.

Personal loans

Pros

• You’ll repay the loan in fixed monthly payments, which can make it easier to budget for than juggling multiple credit card balances.
• They typically come with lower rates than those for credit cards.
• They may make it easier to consolidate multiple debts and balances.

Cons

• They may have higher credit score requirements to qualify.
• They don’t have introductory 0% interest rates.
• They aren’t revolving credit products, so you can’t pull more money from them in the future, even after your balance is paid down. If you need additional funds down the line, you’ll have to apply for a new personal loan.

Balance transfer credit card

Pros

• They commonly offer 0% introductory APRs with no balance transfer fees for a certain period of time, potentially saving you a lot of money upfront.
• They can include cards you already own, helping you avoid opening new accounts or hard credit inquiries.

Cons

• They often revert to double-digit interest rates once the promotional period ends, and can get very costly if you don’t pay the balance in full by then.
• They may come with fees for every balance you transfer onto the card.

Other ways to consolidate debt

You can use several different financial products and approaches to consolidate debt. Here are a few of the most common:

• Home equity line of credit — HELOCs allow you to tap the equity in your home. A HELOC, which is secured by your home, works similarly to a credit card. You’ll have an established credit limit that you can draw from as needed, at an agreed-upon interest rate.
• Home equity loan — A home equity loan is also guaranteed by the equity in your property, and works like a personal loan. You’ll receive a lump sum that you repay in monthly installments at a set interest rate.
• Cash-out refinance — If you’ve built enough equity in your home, a cash-out refinance can allow you to withdraw some of that value in cash, which you can then use for any purpose (like paying off debt). Cash-out refinancing can also allow you to reduce your interest rate or adjust your monthly payment amount.
• Retirement account loan — If your plan allows it, you can use a 401(k) loan or other retirement account to consolidate debt — but this isn’t usually a good option. Depending on the type of account and your age, you may face penalties, interest, and taxes due on the amount you withdraw. Plus, pulling this money out before retirement can derail your future financial security.

Why taking out a debt consolidation loan can save you money

When it comes to getting out of debt — whether that involves credit card balances, medical bills, or other credit accounts — taking out a personal loan for debt consolidation can be a good option.

A personal loan can allow you to reduce high interest rates (especially when it comes to credit card balances), making it easier to knock out your debt for a lower total cost. It also allows you to streamline your debt into one account with one monthly payment, which is easier to manage.

Finding the right personal loan is the first step toward debt consolidation.