Hard times do happen. With constant economic changes, we see people finding it difficult to pay bills, running into debts. And if you’re in debt, searching for a concrete solution to get out quicker lingers on your mind.
In your search for a solution, you may have already heard about debt consolidation. But before moving forward with this decision, it’s essential to know how it works and what impact it has on your credit score.
Get all the details right here.
WHAT IS DEBT CONSOLIDATION?
Debt consolidation, often incorrectly referred to as Debt Settlement (it’s not the same), is the process of rolling multiple, high-interest debts into a single monthly payment and applying for a personal loan to pay them off.
Most people apply for debt consolidation through their credit unions, credit card companies, or banks if the working relationship is excellent. However, if these institutions do not approve such loans, you should explore lenders and private mortgage agencies.
HOW DOES DEBT CONSOLIDATION AFFECT YOUR CREDIT SCORE?
Debt consolidation may affect your credit score, both positively and negatively. It is crucial to put these factors under consideration before moving forward with your plan.
RESULT IN HARD INQUIRIES
When you apply for a loan to pay off your debts, your lender issues a hard inquiry on your credit. Hard inquiries are carried out to ascertain your creditworthiness – the tendency to repay the loan if approved. Hard inquiries impact your credit score, reducing it by 5 points.
Now, if you’re applying for debt consolidation from multiple lenders, they may issue hard inquiries on your credit information. But do not fret. These hard inquiries will not have a compounding effect on your credit score as long as they’re within a period of 14 to 45 days. Thus, these inquiries will be roped into one when your credit bureaus calculate your credit score.
Note that hard inquiries aren’t necessary when you apply for a loan. Take a look at a lender’s website or brochure to see if you meet the requirement for a loan without hard inquiry checks. Some lenders require a soft inquiry (or soft pull) which doesn’t impact your credit score.
YOUR CREDIT UTILIZATION WILL EXPERIENCE CHANGES
Financial institutions and lenders also take a keen interest in your credit utilization ratio. This ratio is the percentage of available credit you make use of at any given time and typically makes up about 30% of your FICO score.
Now, if you have a credit utilization ratio greater than 10% after debt consolidation, your credit score will lose a few points. If you choose to pay the balance with a personal loan, the percentage will drop, and your credit score will improve.
YOU MAY BE TEMPTED TO CLOSE YOUR ACCOUNTS
When people go through a debt consolidation process, they are predisposed to close their old accounts after transferring a balance. If you’re thinking about it, hold that thought. The average age of all your accounts makes up about 15% of your credit score. Thus, older accounts make up better credit scores.
Opening a new credit account and closing your old accounts could lower their average age and increase the credit utilization ratio. These actions will significantly reduce your credit score. We recommend keeping your old accounts (even with zero balances) after a debt consolidation for the sake of your credit report.
IT IMPROVES YOUR PAYMENT HISTORY
If you maintain a record of paying off your debts promptly, your credit score will not be affected. For a fact, it will improve in the long run. Your payment history makes up about 35% of your credit score.
Thus, if you consolidate your debts into a single loan to pay off at lower interest rates, your credit score will face significant improvements.
PROS AND CONS OF DEBT CONSOLIDATION
Debt consolidation comes with several merits and demerits. Let’s check them out:
Pros:
- Streamlines your finances. When you combine multiple debts into a single loan makes it easier to pay them off. You don’t have to worry about numerous payments or interest rates. It also reduces the chances of late payments.
- Lower monthly payments. After consolidating your debts, you will experience lower debt repayments, as your payment plan is spread out over a period.
- Have a fixed repayment schedule. When you consolidate your debts for a loan, you know how much you’ve meant to pay each month and when your last payment will be. You won’t have to worry about random increments in your repayments.
- Boost your credit score. Debt consolidation results in hard inquiries that will impact your credit score. However, when you pay off your loan promptly, it will improve your credit scores. Your payment history is 35% of your credit score, so repaying on time will improve it in the long run.
Cons:
- Added costs. Some debt consolidation loans come with extra expenses such as bank transfer fees, closing costs, origination fees, and annual fees.
- Potential increase in interest rates. If your credit score isn’t sufficient to nail competitive rates of lenders, you may be stuck repaying your debts at a higher rate.
- You risk missing payments. When you miss payments on a debt consolidation loan, your credit score takes a massive hit. You also risk paying extra fees.
- It won’t solve bad financial habits. Even if you consolidate your debts, it will not solve the inherent financial behavior that got you there in the first place. Thus, it is essential to practice reasonable financial behavior to limit unpaid debts.
HOW TO CONSOLIDATE YOUR CREDIT CARDS WITHOUT HURTING YOUR CREDIT SCORE
If you’re looking to consolidate your debts without impacting your credit score, try out these alternatives:
REACH OUT TO A NONPROFIT CREDIT COUNSEL AGENCY
You can sign up for a debt management plan from a nonprofit credit counseling agency. They can help work plans to alleviate your challenges, budget your finances, and work with your lenders to set up payments. Instead of paying your different lenders, you’d only have to make a monthly payment to the agency, which then pays your lenders.
CREDIT CARD BALANCE TRANSFER
Another way you can go about it is to transfer all your current credit balance to a new credit card with zero annual percentage rate (APR). It makes it easier to repay all balances without incurring any interest.
You may likely pay a balance transfer fee of up to 5%, but it’s way better than taking a personal loan.
BUDGET OVERHAUL
You can still pay the debts on your own if you create a feasible budget. Cut down unnecessary expenses and channel the funds into your repayment plans.
TAKE A 401(K) LOAN
Taking a 401(k) loan does not appear on your credit report. Thus, these loans do not impact your credit scores.
TIPS ON HOW TO AVOID HURTING YOUR CREDIT SCORE WITH A CONSOLIDATED PLAN
While you’re repaying a loan for a consolidated debt, there are several tips you should practice to avoid tanking your credit scores. They include:
AVOID TAKING ANOTHER LOAN DURING THIS TIME
You should not apply for another loan while repaying a consolidated loan to a lender. It would involve a hard inquiry which would impact your credit score and reduce your creditworthiness.
AVOID CLOSING YOUR OLDER CREDIT ACCOUNTS
Do not close your older accounts, as the average age of your accounts makes up about 15% of your credit score.
MAINTAIN GREAT FINANCIAL HABIT
Maintaining excellent financial behavior will ensure your loan is timely repaid for your consolidated debts.
FINAL THOUGHTS ABOUT THE PROS AND CONS OF CONSOLIDATING LOANS
Debt consolidation goes a long way in ensuring you pay off your debts in a quicker manner. You don’t have to bother about various interest rates and payment dates. It also helps you budget better before payment day and boosts your credit scores in the long run.
However, debt consolidations come with hard inquiries, extra fees to pay, bad credit scores if you miss payments, and higher interest rates if you’ve already got a bad credit score. It is recommended that you take crucial steps to pay off your loan promptly if you choose to go with it. Is your debt behind you and now looking to improve your credit? Get a free consultation from The Phenix Group.