Debt consolidation can be a smart way to pay off debt in some cases. We have written before about specific debt consolidation strategies that you can use, including balance transfers, consolidation loans, and debt management plans (though DMPs are slightly different than true “consolidation”). But despite some of the perks, consolidation has drawbacks.
One potential drawback is the impact to your credit score. You might be wondering if consolidation hurts your credit. It turns out that the answer is a mixed bag. Some aspects of debt consolidation can hurt your credit score slightly in the short-term. Other aspects could cause positive changes to your credit score over the medium- and long-term. It really boils down to the specifics of your situation and how you manage your debt after consolidation. Let’s take a closer look.
Reminder: Components of a Credit Score
Before we talk about the impact of debt consolidation, it’s important to recap the components of a credit score. A FICO score is made up of your payment history (35%), amounts owed (30%), length of credit history (15%), credit mix (10%), and new credit (10%).
Debt consolidation can potentially impact all of these categories.
First, debt consolidation involves opening a new loan or line of credit (i.e. a balance transfer card). This will involve at least one new credit inquiry and lower the average age of your accounts, which can create a short-term drop in your score. One tip is to do your research first. As Experian points out, by knowing your credit score in advance and researching the loans or credit cards available, you can limit the number of inquiries, protecting your score.
If you use a balance transfer card to consolidate pre-existing credit card debt, you won’t affect your “mix” of debt. However, if you use a consolidation loan and you have not had a loan before, this could have a favorable impact on your credit mix, since you would then have credit cards and a loan on your file.
The greater impacts to your score will come from payment history and amounts owed, since they are the two most heavily weighted categories of your credit score. The term “amounts owed” can be a little misleading, because it is not just about the total debt balance that you owe. What matters more is your credit utilization. This is a ratio of how much credit you are using (total balance) to how much you have available (total credit limit). A high utilization can hurt your score.
All things equal, debt consolidation can improve your credit utilization and therefore improve your credit score. To give a quick example, imagine you had three credit card accounts. Each had a $10,000 credit limit, and on each you had a $5,000 balance. This means you had a total debt balance of $15,000 out of your total $30,000 credit limit. Your utilization was 50 percent. But let’s say you then opened a balance transfer card. We will assume you could move all of your existing debt ($15,000) to the new card, and that the new card had a credit limit of $15,000. Assuming you left your previous cards open, you would now have a total balance of $15,000, but a total credit limit of $45,000. Therefore, your utilization would have dropped to 33 percent, which should have a positive impact on your credit score.
To have an immediately positive effect on your utilization, you will need to leave your previous accounts open. You have to be careful here, and know your personality. If leaving those credit cards open will be tempting—and you might run up additional credit card bills—then it may be better to close them.
However, closing them will increase your utilization and lower your average age of accounts, probably hurting your score in the short-term. So, it can be a difficult choice.
Whatever you decide, the last major category is your payment history. If you have been making regular payments, but chose consolidation simply to get a lower interest rate, then you may not have much difficulty with making on-time payments, and that should help your score. In fact, you may find payments to be more manageable after consolidation. On the other hand, if you are already struggling and you leave old accounts open (again, creating the opportunity that you might spend more than you can repay), this could lead to missed payments and, in turn, hurt your credit score.
Are You Asking the Right Question?
If you are considering debt consolidation or other repayment strategies, it is only natural that you want to know the impact to your credit score. Credit scores are important, particularly when it comes to major financial goals like buying a home. However, you do not want to miss the forest for the trees. You might want to consider what your top priority is. In all likelihood, it’s that you pay off your debt efficiently and reliably.
Debt consolidation, through a balance transfer or consolidation loan, may be the right way to achieve that goal. It is likely a great option if you already have good to excellent credit, can pay off the debt quickly (before promotional interest rates expire), and can avoid some of the hefty fees consolidation loans and balance transfer cards often charge. However, the short-term boost to your credit will not be worth very much if you find yourself in significant debt again in the near future. What’s best for your credit score in the long-term is whatever approach allows you to reduce your debt to a manageable level and keep it there.
If you would like more help deciding which repayment option is best, consider checking out our debt relief comparison guide, or working with a credit counselor.
For more information about other debt repayment options check out our Ultimate Debt Relief Comparison White Paper.