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Impact of a Debt Consolidation Loan on Your Credit Score

by Jesse Campbell on
10/11/2024
in Repaying Debt , Using Credit
Woman reading paperwork on her couch.

Debt consolidation loans can be an effective way to simplify debt repayment and potentially lower your interest rates, but they also come with potential impacts on your credit. Understanding how debt consolidation loans affect your credit score is crucial when deciding whether they are the right solution for you.

What is a debt consolidation loan?

A debt consolidation loan is a type of personal loan that allows you to combine multiple unsecured debts—such as credit card debt, personal loans, or medical bills—into a single loan with one monthly payment. The primary goal is to simplify your financial life, potentially secure a lower interest rate, and make it easier to pay off debt faster.

These loans are typically offered by banks, credit unions, and online lenders, and they may be a good fit for individuals with good credit and a stable income. While a consolidation loan can help you get out of debt, it’s important to consider how debt consolidation affects your credit score, both in the short and long term.

How does a debt consolidation loan affect your credit?

1. Initial impact on your credit score

When you apply for a debt consolidation loan, the lender will perform a hard inquiry on your credit report. This inquiry can cause a temporary dip in your credit score, typically by a few points. If you shop around and apply for multiple loans within a short period, you may see an additional drop in your score due to multiple hard inquiries.

However, if these inquiries occur within a focused time frame (typically 14-45 days depending on the scoring model), they are usually grouped as a single inquiry, minimizing the impact.

2. Changes to your credit utilization ratio

Credit utilization—aka how much of your available credit you’re using—is a key factor in your credit score. If you use a debt consolidation loan to pay off your credit card balances, your utilization ratio will decrease, which can positively affect your credit score. This is because a lower utilization ratio signals to lenders that you are using a smaller portion of your available credit, which is generally viewed as responsible financial behavior.

However, be mindful of your spending habits. If you continue to use your credit cards after consolidating your debt, your utilization ratio may increase again, leading to potential credit score dips and a return to high levels of debt.

3. Effect on your average age of credit

Your credit score considers the length of your credit history, including the average age of your credit accounts. When you open a new debt consolidation loan, it lowers the average age of your accounts, which may negatively impact your credit score in the short term. Additionally, if you close old credit card accounts after paying them off, it can further reduce the average age of your credit, exacerbating the negative impact on your score.

If maintaining a strong credit history is important to you, consider leaving paid-off credit accounts open, provided they don’t come with high fees. This can help you preserve your credit history length and maintain a healthy score.

4. Impact of on-time payments

Making on-time payments on your debt consolidation loan can improve your credit score over time. Conversely, missing payments can cause serious damage to your credit, as payment history is the most influential factor in most credit scoring models.

Since your debt is now consolidated into a single loan, missing a payment on that loan could mean defaulting on what used to be multiple debts simultaneously. Ensure that your new monthly payment is manageable within your budget before consolidating.

What should you consider before applying for a debt consolidation loan?

Before applying for a debt consolidation loan, carefully evaluate your financial situation. Here are some factors to consider when making your decision:

  • Will the loan reduce your monthly payments? Ensure that the new loan payment is manageable within your current budget. If your monthly payment is still too high, you may end up missing payments, hurting your credit score further.
  • Will you get a lower interest rate? A lower interest rate can save you money in the long term. If you can’t qualify for a lower rate than what you’re currently paying, a debt consolidation loan may not be worth it.
  • Will the loan help you get out of debt faster? The purpose of a debt consolidation loan is to simplify and accelerate debt repayment. Make sure the new loan term is shorter or at least comparable to your existing debt terms to avoid extending your repayment period unnecessarily.

Final thoughts: Is debt consolidation right for you?

A debt consolidation loan can be a valuable tool for managing and reducing debt, but it’s not a one-size-fits-all solution. It’s important to weigh the benefits and drawbacks in relation to your personal financial goals and how debt consolidation affects your credit. If used wisely, a debt consolidation loan can help reduce your debt and improve your credit over time. But if you’re not ready to adjust your spending habits or budget, it may only serve as a temporary fix.

If you’re unsure whether a debt consolidation loan is the best choice for you, consider working with a financial counselor. MMI offers free financial counseling 24/7, online and over the phone. Let us help you assess your options and create a personalized plan for getting out of debt and improving your financial health.

Tagged in Debt consolidation, Debt strategies, Build your credit score

Jesse Campbell photo.

Jesse Campbell is the Content Manager at MMI, with over ten years of experience creating valuable educational materials that help families through everyday and extraordinary financial challenges.

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