Debt Consolidation and Impact to Your Credit Score – 2022
Does debt consolidation affect your credit score? That is the main question we’ll be answering here. It’s not a straightforward answer, and there are times when debt consolidation can help your credit score – and others when it may hurt your credit rating in the long run.
Read on to uncover how you could affect your credit score by choosing debt consolidation.
What is debt consolidation?
Debt consolidation is exactly like it sounds. It involves consolidating multiple debts into a smaller number of debts.
To do this, you must take out new credit, such as a debt consolidation loan, and use the money to pay off multiple other debts in your name. You can do this to tackle personal loan arrears, credit card debt or a combination of both.
In doing so, you have reduced the number of creditors you owe, which makes budgeting and keeping up with monthly repayments easier. It could be a great way to make sure you get back on track and avoid any more late payments.
Moreover, you may be able to reduce the cumulative amount you pay by taking out new credit with a lower interest rate. You don’t have to consolidate all of your debts into just one payment if it’s not advantageous; simply consolidating two debts into one can be a step forward.
Note: debt consolidation is a good idea for some, and not so beneficial to others. You should seek free debt advice before attempting to consolidate debt.
The different types of debt consolidation
There are four main types of debt consolidation. You could:
- Use a debt consolidation loan to pay off multiple other debts. Debt consolidation loans are specifically used for this purpose only.
- Use a balance transfer credit card to pay off multiple credit cards. This can only be used for credit card debt, whereas personal loans can be used for loan debts too.
- Remortgaging can release home equity and that money can be used to pay off existing debts. As this is not an unsecured debt, it usually carries more risk.
- Some debt solutions fall within the category of consolidating debt. For example, a Debt Management Plan lumps your debts together and then you make one monthly payment.
Does debt consolidation affect my credit score?
Consolidating your debt may help or hurt your credit score over time, but for the most part, it is not really the act of consolidating debt that decides this. It is how you keep up with monthly payments and manage your finances after deciding to consolidate your debt.
We’ve broken this down for easy understanding.
How does a debt consolidation loan affect credit score?
Applying for a debt consolidation loan will require the lender to check your credit score. You’ll probably need a fair or good credit score for you to be able to be approved for a debt consolidation loan. However, there are lenders who provide these loans for people with poor credit and payment history.
By making an application and causing the lender to check your credit score, a mark is left on the file to show they have made the check. This doesn’t really hurt your credit score, but if you were to erratically apply for many debt consolidation loans after rejections, this can damage your credit history.
The same is true for people who are trying to consolidate their credit cards with a balance transfer credit card. Applying for too many of these cards in a short period of time can be damaging.
If you are applying for debt consolidation loans or balance transfer cards, it’s worthwhile checking your credit rating first. Spotting a mistake and having it removed can make a big difference to any credit application.
DMPs, debt consolidation and credit scores
Debt Management Plans (DMPs) are informal debt solutions that do not appear on your credit report. Therefore, using one as a way to consolidate your debts is not going to have a negative effect on your credit score.
However, some people don’t organise DMPs themselves and choose to have them arranged through debt charities and debt management companies. The former is usually free while the latter is part of personal financial services that comes at a cost, typically included within your one monthly payment.
But as part of any agreement with a debt management company or equivalent provider, they could ask you to close other forms of credit you have while the debt solution is in place. For example, you may have a credit card that you haven’t really used and is not going to be included in the DMP, and they could ask this credit card to be closed.
They ask this because they have a degree of responsibility that you keep to repayments, and without other possible avenues to debt this provides them with more assurances. When you close any other credit you increase your credit utilization ratio. This is the ratio of available credit you have with how much you’re using.
But when your credit utilization ratio increases, your credit score decreases!
Can debt consolidation help my credit score?
Earlier we said that debt consolidation doesn’t really instantly decide if it will benefit or harm credit scores. It’s what happens after that counts and how the individual continues to handle their money.
Debt consolidation has the potential to improve your credit score because it makes budgeting for your new single payment (or fewer payments!) easier. When budgeting is made easier, there is less likely you will overspend and miss payments. A payment default would be recorded on your score, and avoiding this helps it in hindsight.
Furthermore, if you manage to access a new loan with a lower interest rate compared to what you were paying previously, missing payments or not paying in full is less likely. If the new loan only offers high interest, it is probably not going to be worth consolidating your debts.
How can debt consolidation damage credit scores?
Of course, there is potential that credit scores can be damaged if you do not manage finances responsibly and pay the new loan in full and on time. Or if an unforeseen event occurs and it reduces your monthly budget, such as illness and temporary unemployment.
One issue with debt consolidation is that it can give the illusion of less debt because there is now only one creditor. And it does not solve any underlying problem that caused multiple debts in the first place.
Get free debt advice first!
Don’t decide to consolidate debts on a whim and choose free debt advice from a charity first.
You can also learn how to improve credit scores with us here at MoneyNerd in this handy guide!