Credit Sesame discusses if and how debt consolidation affects your credit score.
Debt consolidation has several potential advantages. They include fewer payments, better interest rates and more time to repay. But how does debt consolidation affect your credit score?
Debt consolidation and credit scores: first, the bad news
Most forms of debt consolidation involve using a new loan to pay off two or more old accounts. And applying for a new loan usually means authorizing a “hard pull” of your credit report. According to FICO, each hard pull, or inquiry, causes your credit score to drop as much as five points. That drop is temporary — inquiries remain on your credit report for two years but only impact your credit score for one.
Five points might not seem like a big deal. But what if you apply for more than one consolidation loan or even prequalify with more than one lender? The impact could be minimal or significant depending on the consolidation loan you choose.
How different loan applications impact your credit score
You can apply for some types of financing multiple times in a short period and FICO only counts it as one inquiry. They include auto loans, mortgages, home equity loans and home equity lines of credit (HELOCS). That’s because FICO recognizes consumers often apply multiple times as part of their rate shopping behavior and it doesn’t mean they’re buying a bunch of cars or getting multiple mortgages.
However, if you consolidate with a personal loan or a balance transfer credit card, prequalifying or applying multiple times could knock a lot more points off. If your lower credit scores put you into a different credit grade, it could cause lenders to offer you worse credit terms. Be especially careful about authorizing too many inquiries if you plan to apply for a home loan in the next year. That’s because mortgage rates are highly sensitive to even small credit score changes, and because a tiny difference in interest rate can add up to thousands of dollars over the life of a loan.
Debt consolidation and credit utilization
Once you consolidate your debt, good things may happen to your credit score. Consolidating credit cards reduces your credit utilization ratio. Credit utilization (also called “amounts owed” by credit bureaus) makes up 30% of your credit score. And you should try to keep that ratio as low as possible.
How do you calculate your credit utilization? By dividing your total credit card balances by the sum of your credit card limits. For instance, if you have three cards with credit limits of $3,000, $2,000 and $10,000, your total credit is $15,000. And if your balances are $2,000, $2,000 and $8,000 (totaling $12,000), your utilization is $12,000 / $15,000, which is 80%. That’s very high and would probably drag your credit score down considerably.
How consolidation loans affect credit utilization
But suppose that you consolidate your credit cards. What happens to your utilization then?
That depends on the type of loan you use to consolidate. Remember that credit utilization only counts revolving, unsecured debt. For most people, that’s their credit card accounts. So if you take out an installment loan to pay off the $12,000 in credit card debt, your utilization drops to zero. The calculation is $0 / $15,000 and the answer is zero.
You get the same result if you use a cash-out refinance, home equity loan or home equity line of credit to consolidate your credit cards. Zero credit utilization, even though you owe the same amount of debt. Simply changing the type of debt you have can do wonderful things to your credit utilization and your credit score.
Consolidating with a balance transfer credit card also lowers credit utilization, but not to zero. That’s because the new account is also a revolving credit line, which counts in the utilization calculation. Let’s assume that you consolidate your $12,000 with a $15,000 zero-interest balance transfer credit card. You’d calculate your utilization like this:
- Add up your credit limits: $3,000 + $2,000 + $10,000 + $15,000 = $30,000
- Divide the sum of your credit balances (still $12,000) by your total credit limits.
- Your utilization equals $12,000 / $30,000, which is 40%.
Paying off credit card debt: more good news
Once you’ve consolidated your credit cards, you’ll steadily pay down your new loan balance until eventually it’s gone. As you do this, you’re adding more positive repayment history to your account. Those are both good for your credit score.
As long as you commit to paying your credit card balances in full each month, and make all loan payments within 30 days of their due date, your credit score should keep heading in the right direction.
Dealing with overspending
One of the biggest reasons people fail at debt consolidation is that they run their credit card balances back up after zeroing them out. Then, they have a new consolidation loan in addition to credit card balances. This can do disastrous things to their finances and harm their credit scores.
If you believe that you cannot resist the temptation to overspend, consider credit counseling from a reputable non-profit. And perhaps closing out some or all of your credit cards.
Closing out your credit cards
Your credit counselor might advise you to close some or all of your credit cards. How does debt consolidation affect your credit if you close those accounts?
Closing a credit card voluntarily does not hurt your credit. And closing credit cards if you owe no balances will not harm your credit utilization or your score. However, if you close one or more credit cards and have a balance on an open credit card, your utilization will be higher and it will probably drop your credit score.
If, for instance, you closed out all credit cards except one with a $1,000 limit, charging just $500 would give you a 50% utilization ratio. But if you keep $15,000 of credit open, charging $500 would give you just 3% utilization.
There are two forces in play:
- Closing most of your credit leaves you vulnerable if you need to charge in the future.
- Leaving lots of available credit open leaves you vulnerable to running up balances.
The right decision for you depends on your priorities, debt management skill and discipline. If you’re worried about overspending, close your accounts. But if you’re more concerned about access to credit or your utilization ratio, keep accounts open. If you’re not sure, ask a credit counselor to help you make a budget and recommend a course of action.
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Disclaimer: The article and information provided here is for informational purposes only and is not intended as a substitute for professional advice.