Does Debt Consolidation Hurt Your Credit?
Debt consolidation has the potential to help and hurt your credit score, but the overall effect should be positive if you're able to pay off your debt.
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Debt consolidation can lower your monthly payments and help you get out of debt faster, but it can also cause a minor dip in your credit score.
That’s because applying for a consolidation product — like a balance transfer card or a debt consolidation loan — triggers a hard inquiry of your credit. Hard inquiries temporarily lower your score a few points.
But if you use debt consolidation to successfully pay off your debts, consolidation should help your score in the long run.
It’s easy to confuse “debt consolidation” and “debt settlement.” This article deals with debt consolidation, which is when you combine debt and pay it off in full, ideally with less interest. Debt settlement is when you pay off debt for less than you owe, and it can seriously damage your credit score. Learn about debt settlement lower down.
How does debt consolidation affect your credit?
Debt consolidation has the potential to help and hurt your credit score. If you successfully pay off your debt and avoid too much debt in the future, the overall effect should be positive.
How debt consolidation can help your credit score | How debt consolidation can hurt your credit score |
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Ways debt consolidation can help your credit score
Builds a history of on-time payments: Responsible repayment behavior is the most important factor in calculating your credit score. If you take out a loan to pay off your debt, and then make all the loan payments on time, it could help build your score.
Lowers your credit utilization: Your credit utilization, or the amount of available credit you’re currently using, accounts for 30% of your credit score.
Generally, the lower your credit utilization, the better your score. If you consolidate your debts, then successfully pay them off, your credit utilization ratio should go down.
Helps diversify your credit mix: Juggling a few different types of credit products may help grow your score.
For example, if you have revolving credit, like credit cards, adding installment credit, like a debt consolidation loan, could show credit diversity.
Ways debt consolidation can hurt your credit score
Requires a hard credit inquiry: Applying for a debt consolidation product requires a hard credit check, which temporarily knocks a few points off your credit score.
If you’re interested in a debt consolidation loan, pre-qualifying — a way to check for loan offers — can help you compare lenders before submitting to a hard credit check.
Could increase overall debt load: One of the main risks of debt consolidation is getting into more debt once your existing credit cards are at a zero balance again.
For example, say you move your existing credit card balances to a balance transfer card — then end up using your old cards again. You’ll have more debt than when you started, which hurts your credit score.
Potential for missed payments: In the same way a history of on-time payments can help build your credit score, missing payments can hurt your score.
How to consolidate debt without hurting your credit score
1. Prioritize on-time payments: Keep track of paying down your debt, especially if you choose a consolidation product that requires regular monthly payments, like a debt consolidation loan. Even one missed payment can hurt your credit score.
2. Check your credit report regularly: Keep close tabs on your credit report and look for errors. For example, make sure debts show a zero balance after you’ve consolidated them, and check that on-time payments are accurately reported.
3. Keep consolidated accounts open and balances low: Closing credit card accounts can hurt your score. So even after you consolidate accounts, keep them open, and maintain a balance at or near zero.
4. Avoid opening new lines of credit: While you’re paying down debt, avoid opening nonessential lines of credit, like store credit cards. This prevents hard inquiries and reduces the temptation to go into more debt.
Ready to consolidate your debt? Here’s how
There are different ways to consolidate your debts. The best choice depends on your credit score, how much debt you have and what resources you have available to you.
Apply for a balance transfer card
A balance transfer card is a type of credit card you can move all your existing credit card balances onto, and then pay them down all at once.
The biggest benefit is that most come with a 0% interest promotional period, sometimes lasting up to 21 months. During this time you’ll pay no interest on your balance, which means you can pay it down faster.
To qualify for a balance transfer card, you’ll need good to excellent credit (a score in the mid-600s or higher). There’s typically a balance transfer fee, which is usually 3% to 5% of the amount being transferred.
Lastly, keep in mind that like any credit card, a balance transfer card has a credit limit. So make sure the limit is high enough to cover your total debt.
» COMPARE: Best 0% balance transfer cards
Take out a debt consolidation loan
If you can’t qualify for a balance transfer card, or the limit is too low to cover your existing debt, consider a debt consolidation loan.
These loans are available to borrowers across the credit spectrum and come in amounts of $1,000 to $50,000. They have fixed interest rates and fixed repayment terms. That means you’ll pay the same amount each month, making the payment easier to budget for. You’ll also know the exact date you’ll be debt-free.
Make sure you get a loan with a lower rate than the average rate on your existing debts. (NerdWallet’s free debt consolidation calculator can help you calculate this.)
Once you apply and are approved for the loan, you’ll use the funds to pay off your debts, so you’re left with only the loan payment.
» COMPARE: Best debt consolidation loans
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Borrow from your 401(k)
If you have a 401(k), you can borrow up to half the amount, with a $50,000 maximum, to pay off your debts. These loans typically have low interest rates, and any interest you do pay goes back to your 401(k).
Still, this is one of the riskier debt consolidation options and should be a last resort. Taking out a 401(k) loan can significantly impact your retirement, and you’ll lose out on the money you could have made if that money was still invested.
Also, if for some reason you can’t repay the loan, you’ll owe taxes and potentially a large penalty. And if you leave your job, the loan may be due soon after.
» MORE: What to know about 401(k) loans
Tap your home equity
If you own your home, you could use your existing equity to pay off your debts through either a home equity loan or a home equity line of credit. Equity is the market value of your home, minus what you owe.
A home equity loan is a lump-sum loan that you pay back with a fixed interest rate, similar to a debt consolidation loan. A home equity line of credit, or HELOC, works more like a credit card in which you only borrow what you need and typically pay it off monthly.
Keep in mind it’s generally not a good idea to replace unsecured debt (like credit card debt) with secured debt (like a mortgage), because you could lose your home if you can’t pay.
Like a 401(k) loan, consider this a last resort option.
Other ways to pay off debt and how they affect your credit
If the above options don’t seem like a good fit, there are other ways to pay off debt.
DIY methods
The debt snowball and debt avalanche are two do-it-yourself debt payoff strategies that can be very effective.
With the snowball method, you tackle your smallest debt first and work your way up to larger debts. Quick wins at the outset can help build momentum.
With the avalanche method, you pay off your highest interest debt first, then your second highest and so on. You can then apply your interest savings to each new debt.
How it affects your credit: Since you’re not applying for new credit, DIY debt payoff methods won’t cause a temporary dip in your credit score. Plus, as you pay off debt, your credit utilization should go down, which helps elevate your credit score.
Debt management plans
A nonprofit credit counseling agency can help you get debt under control by placing you on a debt management plan. These plans are low-risk and low-cost and help to consolidate multiple debts, like credit cards, under a lower interest rate.
How it affects your credit: Debt management might cause a temporary dip in your credit score when you first enroll in the plan. As you successfully pay off the debt, your score should recover and potentially climb.
Debt settlement
Debt settlement is when you settle your debts for less than you owe. This is usually done with the help of a debt settlement company, which negotiates with creditors on your behalf. Debt settlement is risky, so explore alternatives first.
How it affects your credit: Debt settlement can trigger late payments and collections activity, which will be reported to the credit bureaus and badly damage your score. Successfully settled debts stay on your credit report for up to seven years.
Bankruptcy
If your debt is more than 40% of your income and you can’t pay it off within five years, bankruptcy may be an option. There are different types of bankruptcy, but most consumers file for Chapter 7 bankruptcy, which erases debts like credit cards, medical bills and personal loans.
How it affects your credit: Filing for bankruptcy typically stays on your credit report for seven to 10 years, depending on which type of bankruptcy you file for.
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