How to consolidate debt without hurting your credit

A recent economic health study from financial services provider Northwestern Mutual found that the average American has $22,713 in consumer debt, not counting home loans. The main source of debt is credit cards, followed by auto loans in a distant second place and student loans in third place.   

Debt consolidation may provide some financial relief if you owe a lot of money across multiple credit cards and loans. Before taking that step, you should be familiar with the types of debt consolidation, its pros and cons and how to do it with minimal negative effects on your credit.

What is debt consolidation?

Debt consolidation is the process of rolling multiple debts into a single account. This strategy can make your life easier by allowing you to focus on one monthly payment instead of multiple payments with different amounts due to different creditors on different dates. 

In some cases, debt consolidation can also lower your overall interest rate to help you save money in the long term.

Methods of debt consolidation

Debt consolidation is most often done through personal loans, balance transfer credit cards and home equity loans or lines of credit.

Personal loans

A personal loan gives you a lump sum of money, which you can use to pay off your existing debt balances. You repay the new personal loan in monthly installments over months or years.

Personal loans generally have a fixed interest rate, meaning the interest rate won’t change during the life of the loan. This can make budgeting easier because your monthly payments will remain stable from one month to the next. 

The interest rate you owe (and the amount of money you can borrow) depends on factors like your credit score, the loan term and the lender you choose.

Balance transfer credit cards

A balance transfer credit card lets you move existing debt from several credit cards to a single card. Some specialized credit cards offer an introductory annual percentage rate (APR) as low as 0 percent. 

Depending on the card you choose, you may have 12–18 months without accruing interest. However, the cards may have higher than average interest rates after the promotional period. It’s best to use this approach only if you can pay it off during that time.

Home equity loans or HELOCs

Home equity loans and home equity lines of credit (HELOCs) allow homeowners to convert a portion of their home equity into cash, which can be used to consolidate debt. Both tools are secured loans that use your home as collateral but work differently:

• A home equity loan is a second mortgage (typically with a fixed interest rate) that pays out a lump sum. The loan amount is repaid in monthly installments, beginning immediately. 
• A HELOC is a revolving line of credit (typically with a variable interest rate) that allows you to borrow against a portion of your equity as needed. You could potentially borrow enough to pay off your consumer debts, repay the HELOC in installments and then tap the credit line again for future expenses. HELOCs may offer a period of interest-only payments, which could provide relief from temporary cash-flow issues. 

Because your home secures home equity loans and HELOCs, they typically offer lower interest rates than other types of debt. However, failure to repay the loans could result in foreclosure on your home. Consolidating debt is not a decision to enter into lightly. 

How debt consolidation can affect your credit

Debt consolidation can negatively impact your credit score in a few ways. 

If you get an installment loan and pay on time, for example, your credit score might improve if you reduce the interest rate and can pay off your credit cards in full every month. Still, it’s important to recognize what negative effects could happen. 

The hard inquiry

Any debt consolidation method you use will have the creditor or lender pulling your credit score, leading to a hard inquiry on your credit report. This inquiry can temporarily decrease your credit score by a few points.

Change in your credit utilization

Credit utilization is the amount of credit you currently use compared to what is available. This accounts for 30 percent of your credit score. The lower your utilization, the better. 

Debt consolidation can lower your credit utilization by paying off your high-interest, high-balance credit cards with the loan. When you do that, the credit cards use only a little of your overall credit limit. 

However, if you close those accounts and replace them with one that is maxed out (or close to), your utilization ratio will plummet, likely decreasing your credit score.  

A change in your credit mix

The different types of debt you carry create your credit mix, which accounts for 10 percent of your credit score. This is meant to show how you handle different types of debt (like installment loans compared to revolving credit lines such as credit cards, for example). 

If you add an installment loan when you only had credit cards before, your credit mix will increase. 

Length of credit history

The average age of your open accounts makes up 15 percent of your credit score. The longer your accounts are open, the better for your score. 

If you close an account, the average age decreases. If you close accounts and open a new one during a debt consolidation, your length of history could decline substantially, causing a drop in your score. 

You very rarely need to close accounts to consolidate debt, however. You can keep an account open even if you don’t use it.

New credit applications

New credit applications account for 10 percent of your credit score. Opening one new line of credit or accepting one new loan won’t have much impact, but taking on multiple new debts in a short time frame could.

Future payments

Payment history accounts for a whopping 35 percent of your credit score. Payments at least 30 days late on your new consolidated loan can sink your score. However, if consolidation helps you pay on time, your credit score will likely improve over time.

How to consolidate debt without hurting your credit

While you can’t avoid all hits to your credit score when consolidating debt, you can minimize the impact and repair damage faster with these tips:

• Stop using your credit cards. Cut up those credit cards and remove them from your digital wallets so you’re not tempted to increase your debt utilization ratio. 
• Pay your bills on time. Making consistent, on-time payments on your consolidation loan or balance transfer credit card will help boost your overall credit score. Plus, as you pay down your balance, your credit utilization goes down, which can increase your credit score.
• Keep credit lines open whenever possible. This will keep your length of credit history intact.  
• Avoid opening new accounts for a while. This will help you maintain your length of credit history and avoid hits from inquiries and new credit.  

Pros of debt consolidation

Managing your payments through debt consolidation can offer plenty of benefits, including:

• Fixed repayment schedule: Replacing variable-rate credit card debt with fixed-rate loans or 0 percent APY cards can keep your monthly payments stable. 
• Lower interest rates: Depending on your credit score, you could pay a lower interest rate through a personal loan, credit card transfer, home equity loan or HELOC. 
• Simplified debt payments: Consolidating multiple debts into one account reduces the monthly payments you must worry about. 

Cons of debt consolidation

It’s also important to understand the possible downsides of consolidating debts:

• Damage to your credit score if you can’t pay: Once your payment is more than 30 days past its due date, your creditor or lender might report the omission to the credit bureaus.
• Longer payoff terms: You could pay less per month with a debt consolidation plan. However, you might be paying this off over a longer time. If so, you might pay more in interest.
• Upfront costs: Loans typically come with origination fees, which vary by lender. Balance transfer credit cards often charge fees of 3 to 5 percent of the transfer amount.

How to decide when debt consolidation is a good idea

It’s a good idea to weigh a few important factors when considering debt consolidation:

• Your ability to repay: Don’t get a debt consolidation loan unless you can repay it. Missing payments could drive you deeper into debt and lower your credit score.
• Your credit score: One goal of debt consolidation is to reduce the interest rate on your debt. The idea here is to pay a lower interest rate on a consolidation loan or balance transfer credit card than you currently have. This is doable with a “good” credit score, which is at least 670 (FICO) or 661 (VantageScore). 
• Your budget and financial goals: Debt consolidation could make your payment period longer. It can also provide a route to a specific, fixed monthly payment. This might be ideal if you’re working within a specific budget.

The bottom line

Debt consolidation doesn’t reduce the amount you owe but can help you pay debt down more efficiently. Personal loans, balance transfer credit cards, home equity loans and HELOCs are all viable options for consolidating multiple debts into one account. 

To protect your credit while consolidating debt, keep credit lines open whenever possible, stop using your credit cards and avoid opening new credit lines. As you make your consolidated payments in full and on time each month, your credit will recover from the temporary hit, and you’ll have more control over your debt.