How to consolidate debt without hurting your credit
Key takeaways
- Debt consolidation puts multiple debts into a single account to make your payments easier to manage.
- Consolidating debts may temporarily reduce your credit score, but your score will improve over time as long as you make payments on schedule.
- You can minimize the impact on your credit through strategies like keeping credit lines open and avoiding new debts.
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.
Consolidating your debt could save you a lot of money. I saved thousands of dollars in interest when taking out two personal loans to pay off my credit card debt almost seven years ago. But if you’re thinking about taking the same route, you may wonder if it’s possible to consolidate debt without hurting your credit.
Applying for new credit usually results in a hard inquiry, which typically dings your credit. As a result, it’s almost inevitable that debt consolidation will have a short-term credit impact. However, there are some steps you can take to lessen the effect it has. If you pay off the new loan on time, it could even help strengthen your credit profile over time.
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.
Pros and cons of debt consolidation
Pros
- Fixed monthly payments
- Potential to secure a lower rate
- One monthly payment
Cons
- Failure to pay can harm credit
- Extending repayment terms could increase borrowing costs
- Possible origination or balance transfer fees
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 12–21 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.
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.
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.
