Credit 101

Will Debt Consolidation Help or Hurt Your Credit?

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When you are trying to get out of debt, consolidating credit cards or other loans can save you time and money. But does debt consolidation help or hurt your credit? The answer depends on how you consolidate — and what you do afterwards.

Debt Consolidation Loans

Getting a new loan to pay off other debts is the most popular way to consolidate. It’s certainly what most people think of when they think of consolidation. But finding a loan with decent terms for this purpose can sometimes be challenging — especially if your credit scores are a bit lower due to the balances you are carrying.

It’s certainly not impossible, though. Peer-to-peer lenders like LendingClub.com and Prosper.com, for example, routinely make these kinds of loans to borrowers with good credit. Your bank or credit union may also be willing to help you consolidate, and there are some online lenders that offer consolidation loans. (Tip: Triple check to make sure you are dealing with a reputable site if you are shopping for a loan online. Scams abound.)

Effect on Your Credit: Consolidating credit cards with high balances using an installment loan — a loan with fixed monthly payments — may actually benefit your credit rating, especially if you use the loan to pay off credit cards that are near their limits. At the same time, any new loan can cause a short-term dip to your credit scores — so don’t be surprised if that happens.

Debt Management Plans

Though often confused with debt consolidation, a debt management plan (DMP) is somewhat different. These programs are offered through credit counseling agencies and, strictly speaking, they don’t actually consolidate your debt. Instead, you make a “consolidated” payment to the counseling agency, which then pays each of your creditors, usually at a reduced interest rate and payment. Even though you are only making one or two monthly payments, the counseling agency doesn’t actually pay off your creditors. Still, these programs are available regardless of credit scores, so if you are having trouble consolidating due to the fact that you are maxxed out on one or more of your credit cards, a DMP may be worth considering.

Effect on Your Credit: You will be required to close most, if not all, of your credit card accounts while on a DMP and that will affect your credit scores. On the other hand, FICO ignores any notation that you are paying your debt through a counseling program when calculating your scores. So it will affect your credit, but it may not be as bad as you fear.

The Credit Card Shuffle

Transferring a high-rate credit card balance to a card at a lower rate can be another way to consolidate. Carrie Rocha, author of Pocket Your Dollars: 5 Attitude Changes That Will Help You Pay Down Debt, and her husband paid off some $60,000 in debt, and taking advantage of low-rate balance transfers was one of the strategies they used to dig out. However, if you decide to go this route it is important to be very disciplined in your approach. Otherwise, you may fall into traps such as getting stuck with a balance at a high interest rate after the introductory period ends.

Effect on Your Credit: Depends on how you use a transfer. If you use a substantial portion of the available credit on the card to consolidate balances from other cards with lower balance-to-available-credit ratios, your credit scores may drop. You may also lose points if you open a new card and use a substantial portion of the credit line to consolidate. However, if a 0% card allows you to save money and pay off your debt faster, you can come out ahead in the long run both financially and credit score-wise.

Less Debt = Stronger Credit

Paying down debt can have a tremendous impact on your credit scores. According to FICO, the company behind most of the credit scores used by lenders, consumers with high credit scores (785 and above on a scale of 300 – 850), tend to keep their balances low. Specifically, two-thirds carry less than $8,500 in non-mortgage debt, and they use an average of 7% of their available credit on their credit cards.

That means that paying off debt, whether you use a consolidation loan or just put every penny you can toward your debt, can often be helpful to consumer’s credit ratings in the long run. The biggest risk, though, is that it’s easy to run up new balances on the cards that have been paid off in the consolidation. And that’s definitely not a good move for your credit or your bottom line.

Remember, moving around debt is not the goal here. The goal is to pay off those balances to free up cash flow as well as to help build strong credit. A consolidation loan, used right, can help you get there just a little faster.

Image: brewbooks, via Flickr

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  • ElbonianGA

    One problem with a debt consolidation personal loan: some scoring models lower your credit score if you have too many installment loans. For instance, if you have two car loans and take out a Lending Club or Prosper loan for consolidation purposes your credit score can go down on some models simply because you now have 3 installment loans. The size of the payments on all of your installment loans can also be a factor that some models consider.

    Nonetheless, a Lending Club loan did work for me to get out of the 600s and into the 700s for a few weeks between the time I used the loan to pay down my credit cards and before the Lending Club loan was reported on my credit report (becoming my 3rd installment loan). In that interim time period I applied for a Discover IT card with a 0% APR and further consolidated my remaining credit card debt onto that card. Now, I just need to pay off one of my two car loans and then I’ll hopefully get back into the 700s once again…..

  • http://www.Credit.com/ Gerri Detweiler

    As we mention in the article, over time it can help your credit. Initially there may be a dip due to the new debt but if you pay it off on time if should even out. There are no guarantees, of course, but that is often how it works. And keep in mind the main goal – to get out of debt!

  • doober

    What about consolidating student loan debts? Would that help credit overall? I have several student loan debts that have defaulted, but I have been on a payment plan for around 6 months. Will consolidating now help me?

    • http://www.Credit.com/ Gerri Detweiler

      Student loan consolidation is a different animal. Are you currently in rehabilitation on your student loan? If so you want to complete your rehabilitation program so you can get out of default. You can also check the National Student Loan Data System to learn more about your options.

  • Psychoholic

    If I get a loan and say I’m paying off a car in that loan do I still have to have full coverage on my car? I was looking into a loan from lending club to pay all my credit cards and her car loan off so we can just make on easy monthly payment thanks..

    • http://www.credit.com/ Credit.com Credit Experts

      A lender may often require more coverage on a car when it is their collateral for a loan, but once the car belongs to you (and the loan is paid off), you are free to drop coverages not required by your state. Some owners of older cars decide to drop comprehensive and collision coverages, for example. (Canceling liability coverage is never a good idea.)

  • http://www.Credit.com/ Gerri Detweiler

    The car loan is different than the credit cards when it comes to maxing out the loan amount. (A car loan is an installment loan so the debt usage ratio isn’t much of an issue there, if at all.)

    If you want to consolidate the credit cards, that’s fine but you don’t need to worry about doing the same with the car loan. The only reason you might want to consolidate the car loan would be because you can get a better interest rate. But I would not recommend you consolidate the car loan with either a higher rate loan or a longer term loan.

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