Does Debt Consolidation Damage Your Credit?
- Debt consolidation involves replacing a number of different loans, credit cards and other types of debts with a single loan or credit account. It takes less time to manage and pay one credit account than it takes to manage several. If you pay off high-interest-rate credit cards with a low-interest loan then you save money in terms of interest, and more of your monthly payment actually goes toward reducing the principal. From a credit score perspective, your credit activity drops when you consolidate your debts, which means that your credit score largely depends on how you manage your new consolidation loan.
- Your credit score drops slightly when you open a new account, such as a consolidation loan, but your score eventually recovers if you pay the debt on time. New accounts and credit inquiries as a whole account for about 10 percent of your credit score. The amount you owe relative to your available balances accounts for about 30 percent of your credit score. If you pay off and close all of your credit accounts with a consolidation loan then your credit report shows that you are utilizing 100 percent of your available credit in the form of the new loan. Your length of account history accounts for 15 percent of your credit score, and if you close your existing accounts then this average falls and your credit score as a whole takes another hit.
- The credit agencies assign you a credit score that falls somewhere between 300 and 850. If you only have one open account then that account has a huge impact on your score, but your past credit history also has an impact, as do other factors such as past delinquencies or foreclosures. Therefore, you cannot reliably predict the precise impact that a debt consolidation will have on your score. However, if you take advantage of your interest savings by paying extra money to your principal then you can quickly reduce the balance of your loan. The credit agencies will raise your credit score if you make your monthly payments on time, although it could take several months before you see an improvement in your scores.
- Some companies promote debt consolidation loans that involve you taking out a loan for less than the sum total of your debt. The consolidation loan lender negotiates reduced payoffs with your existing lenders. If you settle your existing debts for less than you owe, your credit score suffers because you have basically reneged on the original loan contracts. Aside from harming your credit score, debt settlement companies usually charge large fees and high interest rates. Therefore, you should only consider these plans if you have no other viable options.