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Debt consolidation loans usually do not hurt your credit in the long term. Hard inquiries that occur when you apply for a loan can briefly affect your score. Conversely, making your loan payments on time can gradually improve your credit.
Debt consolidation loans usually do not hurt your credit in the long term. These loans can improve your credit by combining your debt into one account. But debt consolidation can initially knock your score down a bit, so it’s important to learn as much as possible about this strategy.
How does a debt consolidation loan work?
Debt consolidation combines multiple debts into a single loan. This reduces your overall interest and helps you organize your debt, making payments more manageable. Debt consolidation loans won’t hurt your credit in and of themselves.
However, hard inquiries that occur when you apply for a consolidation loan can temporarily lower your credit score. There are several ways to consolidate your accounts, and each method has advantages and drawbacks depending on your unique circumstances.
Personal loan
A personal line of credit, or personal loan, is available at any time and can be used to pay off debt quickly. Personal loans can improve your credit by diversifying your credit profile. Paying off debt with a loan rather than with a credit card can also reduce your credit utilization, which may improve your credit health.
Remember that this process involves taking out a loan that you must pay back on time. You may also want to reconsider this option if your current credit rating will limit you to high interest rates on personal loans.
Borrowing from a 401(k)
If you have a 401(k) retirement account, you can borrow up to half this balance as an interest-free option to pay off debt. Borrowing from a 401(k) doesn’t affect your credit, though you must repay the borrowed amount in five years to avoid penalties.
It’s important to remember what a 401(k) is for—retirement. Taking out funds for short-term debt payments can significantly detract from your retirement savings. You may also have to deal with tax repercussions when taking this action.
Home equity loan or line of credit
Home equity loans or lines of credit are perhaps the riskiest forms of debt consolidation, but they also offer some significant benefits. Lenders will offer you a loan and use your home as collateral. If you fail to pay off the loan within the amount of time agreed upon, you could lose your home.
You must have excellent credit to take out a home equity loan or line of credit. When you apply, lenders will hit you with a credit check, which could initially lower your score. The impact on your credit may not be severe, but these loans can also accumulate very high interest.
How does debt consolidation affect your credit?
Each debt consolidation method can affect your credit positively and negatively. Here are a few areas it may have a negative impact:
- Credit applications: Applying for a personal loan or a balance transfer card prompts a hard inquiry to be performed on your credit. Hard inquiries can bump down your score by 5 to 10 points, and they can stay on your report for one to two years.
- Average age of credit: The ages of your credit accounts matter—typically, the older, the better. Opening a new account lowers your average credit age, which may initially negatively impact your credit.
On the other hand, debt consolidation tends to positively impact the following categories:
- Credit utilization: A new debt consolidation account will usually increase the amount of available credit you have. As long as you don’t begin spending significantly more after opening the new account, you’ll be using less of your available credit, which will benefit your credit.
- Payment history: Consistently paying off your new loan on time will likely positively impact your credit.
Alternatives to debt consolidation
If debt consolidation doesn’t feel right for you, there are other debt relief options to help restore your peace of mind.
Balance transfer
A balance transfer lets you move debt onto a single credit card with a lower interest rate, allowing you to pay off your debts for less. Many balance transfer cards offer 0 percent APR during an introductory period, providing an interest-free window to pay off debt.
If you decide to pursue a balance transfer card to pay off debt, investigate the card’s APR following the introductory period. Your interest rate may take you by surprise and skyrocket if you don’t do your due diligence.
Debt management program
Debt management services can help by counseling you regarding your options when you’re struggling with debt. A debt management program will likely involve a counselor negotiating lower interest with creditors and potentially closing credit cards.
Visiting a debt management counselor won’t harm your credit at all. However, your credit report may reflect any debt management programs you enroll in until you no longer use them.
Debt settlement or bankruptcy
Debt settlement is negotiating with creditors to pay significantly less money than you owe to have your debt forgiven. Bankruptcy is a long-term legal process that helps people organize and sometimes eliminate their debt.
These two options should be a last resort when struggling to pay off debt, as they can have a significantly adverse effect on your credit. Both debt settlement and bankruptcy will remain on your credit report for seven to 10 years. However, if you need to take care of massive debt now and take wise financial steps in the future, these processes could ultimately be the right solution for you.
Should I consolidate my debt?
Before pursuing debt consolidation, it’s important to take a comprehensive look at the reasons you’re interested in consolidating debt and your plans for the foreseeable future.
Do you have a high interest rate?
If the interest on the debt you owe is 20 percent or more, you’ll likely save money by consolidating debt. However, certain balance transfer options charge exorbitantly high fees. Research beforehand to determine which option saves you more money.
Are you missing payments?
Keeping track of all of your accounts can be stressful. If remembering to pay your bills has been a struggle, and you’ve repeatedly missed payments, debt consolidation may help.
Consolidating your debt could simplify your financial life by allowing you to take care of all payments at once. This will also benefit your credit in the long run, since missed and late payments can harm your credit health.
Do you need excellent credit in the short term?
If you plan to take out a loan or a mortgage soon, you may need to safeguard your credit at all costs. Since many debt consolidation methods will put a temporary dent in your credit, it may be wise to hold off until after a lender has approved you.
Ultimately, whether you decide to pursue debt consolidation and which method you choose depends on the weight of your debts and what would benefit your credit most. If you’re still on the fence, it’s a good idea to consult a financial advisor before making decisions that could have long-lasting consequences.
Whatever decision you make, remember to keep your credit health at the forefront of your mind and take the steps to repair your credit to expand your financial opportunities.
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