Debt consolidation loans can ding your credit in the short term, even if they help you improve your credit score in the long run.
When you take out a debt consolidation loan, you are not paying off your debt. Rather, you are moving it around.
Now, there can be some good reasons to consolidate. For example, a consolidation loan can lower your total monthly payments, giving you some margin or room in your budget. Better still would be a debt consolidation loan that reduces the interest you pay.
How Debt Consolidation Loans Damage Credit
Back to your credit score, here are a few ways a debt consolidation loan can hurt your rating.
- Hard Inquiries. When you apply for a debt consolidation loan or a balance transfer credit card, the lender will perform a hard inquiry on your credit report, which can temporarily lower your credit score.
- New Credit Accounts. Opening a new credit account —precisely what you are doing with a debt consolidation loan— can also decrease the average age of your credit, which is a factor in your credit score. So, too many new accounts and FICA falls.
- High Credit Utilization Ratio. If you transfer all your balances to one card or loan and close other accounts, your credit utilization ratio will increase, which can negatively affect your score. Again, this is the case if the percentage of available credit you use increases.
- Missed Payments. If you use a debt settlement company to facilitate your consolidation, they may advise you to stop payments while they negotiate. Missed payments can significantly harm your credit score.
There are also a few potential benefits that a debt consolidation loan can bring to your credit too.
- Improved Credit Utilization Ratio. If you consolidate multiple balances into a new loan or credit card with a higher limit and do not max it out, you can lower your overall credit utilization ratio. This, in turn, might boost your credit score significantly. The key is to keep old accounts open as you move the balance to your debt consolidation loan.
- Payment History. Over time, consistent on-time payments on the consolidated debt can improve your credit score. So, if having more room in your budget makes it easier to pay on time, this could be a boon.
Debt Consolidation Loans Don't Change Habits
Credit score should not be your only or even your primary consideration when you are thinking about a debt consolidation loan. Instead, your goal should be to use the loan as a tool to improve your financial condition.
A debt consolidation loan does not change your spending habits. If you have been living above your means, consolidating debt can sometimes fuel the downward financial spiral. Dave Ramsey has suggested that more than 80 percent of folks who take out a debt consolidation loan, don't actually get out of debt.
Reasons to Take a Debt Consolidation Loan
There are some times when a debt consolidation loan does improve your financial condition. When is that? When some specific criteria are met.
- Lower interest overall. It can make sense to take a debt consolidation loan when it lowers the overall interest you pay over the debt's life.
- Saves money overall. It can also make sense to consolidate debt to save money overall. Here is an example. Imagine your child is about to head to college. Instead of taking out a student loan that might follow you or your kid for the next three decades, you consolidate your debt to lower your payments and pay tuition now.
Follow the Debt Rule
Debt of any kind is a tool. So use it as such. Here is what I recommend.
Use debt to purchase assets and pay upfront for everything else.