When high-interest debt like credit cards and personal loans takes hold of your financial life, it can be difficult to manage multiple payments and accruing interest each month. Through debt consolidation, you have the opportunity to combine multiple debts into a single, fixed loan that carries predictable monthly payments and often a lower interest rate than credit cards.
While a debt consolidation loan is helpful in terms of money management from month to month, many wonder if there is an impact on their credit score in the process.
Here’s how debt consolidation affects credit in both the short and long term.
An Immediate Dip in Your Credit Score
All lenders offering personal loans as a means to consolidate high-interest debt require an application from potential borrowers. Part of the application process includes a credit check which results in a hard inquiry line item on a credit report.
Although hard inquiries have a minimal effect on a credit score calculation, a new entry may result in a slight dip in a score immediately after an application is submitted. If multiple loans are applied for at the same time, borrowers will most likely experience a drop in their credit score of a few points for each inquiry.
Once a debt consolidation loan is approved, a borrower’s credit may take another slight hit. Credit score calculations are based heavily on how much credit is available to an individual, how much of that available credit is used, and the length of time a credit account has been established.
When a debt consolidation loan appears as a new credit account, a borrower’s credit score may drop because no payments have been made to reduce the balance owed just yet.
Credit Score Improvement Over Time
The good news is that despite the potential reduction in a borrower’s credit score after a debt consolidation loan is funded, over time, a new loan helps the credit score calculation. As the principal balance is paid off, credit score algorithms take into account the reduced loan amount owed compared to the amount initially borrowed.
Additionally, making on-time payments – a significant component in the credit score calculation – creates a track record of good financial behavior that boosts a credit score exponentially.
Using a debt consolidation loan to pay off other revolving credit accounts also improves one’s credit score over time. This frees up some available credit for future use. So long as a borrower is responsible with the repayment of a debt consolidation loan, all signs point to improvement of his or her credit score as the loan is paid down.
Other Debt Consolidation Options
Taking out a new personal loan is the most common method to accomplish debt consolidation. However, some borrowers may not qualify for a loan based on their past credit activities. When that is the case, debt settlement may be an option.
Unlike debt consolidation, debt settlement is the process of negotiating with creditors to reduce the amount owed on credit cards or other debts. The debt settlement company collects a fee for helping a borrower with this service. A monthly payment plan is created to help pay down the negotiated balance for each creditor.
While debt settlement can be a viable option for those who cannot get a debt consolidation loan easily, this alternative may have a negative impact on one’s credit score. Instead of showing debts being zeroed out with the help of a new loan, debt settlement appears as a note on each creditor entry in a credit report. This may be viewed as a negative to new lenders in the future.
The Bottom Line
Getting access to credit cards and other high-interest debt is relatively easy; getting out from under the weight of that debt is not always a simple task. Consider your options for a debt consolidation loan carefully. Be sure to create a plan for repayment before accepting a new loan.
When a debt consolidation loan is not an option due to bad credit or tight cash flow each month, debt settlement may be the next step. No matter the option you choose, take the time to understand the implications to your credit both now and in the future.
