On a personal level, debt makes it hard to live on your own terms.
Your paycheck flies out of your bank account before you can even see it. You’re constantly calculating every expense to the dollar before payday. And in those dark moments when you let yourself calculate how much money you’re spending on credit cards and loans every year, you’re hit with instant feelings of “I could have had it made by now!”.
With the average American owing $90,460, debt consolidation makes sense in many cases. So if you’re looking for an answer to the question “Do debt consolidation loans hurt your credit?”, you’ve come to the right place.
We’ll tell you everything you need to know about debt consolidation and credit. All you have to do is keep reading.
What Is a Debt Consolidation Loan Exactly?
In simple terms, a debt consolidation loan is a personal loan that you can use to combine, or consolidate, your debts.
On its own, this might not sound like a particularly big deal. But when used as part of a larger debt management strategy, being able to consolidate debt can simplify your finances while also allowing you to save on interest in the long run.
If you’ve got multiple credit cards, a couple of personal loans, and a student loan balance that you’re paying down each month, a debt consolidation loan could be an option worth exploring.
The Five Factors That Can Make or Break Your Credit Score
Before we get into the nitty-gritty details of how debt consolidation can affect your credit, it’s important to have a solid overview of how your credit score works. Although many lenders will put on a big show about how they can’t formally approve your loan application without making personal assessments, the factors that loan specialists and underwriters will be looking at to assess your creditworthiness are actually common knowledge.
For instance, your FICO credit score is calculated based on these five weighted factors:
- Payment history (35%)
- Outstanding balances (30%)
- Length of credit history (15%)
- New credit (10%)
- Credit mix (10%)
If you make any financial decisions that impact these categories, like miss a payment or take out too many credit cards at once, your credit score will change accordingly.
Here’s How Debt Consolidation Might Harm Your Credit
We’ve given you a solid overview of what debt consolidation is and how credit scores work. Now it’s time to start talking about how taking out a debt consolidation loan might affect your credit standing. By our count, there are two ways that debt consolidation can lower your score:
1. Applying for More Credit Will Prompt a Hard Credit Inquiry
When you apply for a loan to pay off your debts, your potential creditor will run what’s known as a hard credit inquiry. This is the part where lenders and their underwriting departments review your credit reports during the application process.
Because credit applications represent an element of risk for lenders, a debt consolidation loan can cause a short-term dip in your credit score. This is especially true if you apply for a loan through multiple lenders.
2. Your Average Account Age Will Go Down
All things being equal, if you were a basketball team captain and you had to choose between a player who just learned how to dribble yesterday and LeBron James, you’d be crazy to overlook the world-famous MVP-winning player in favor of the newbie. Sure, the player who’s just getting started could eventually become a superstar. But if you need someone to make a jump shot today, it just makes sense to go with LeBron.
Believe it or not, lenders go through a similar reasoning process when it comes to valuing the age of your credit accounts. If you’ve been making payments for the past few decades, your lender will see you as a more reliable borrower than someone who has only been using credit for a couple of years. Because your consolidation loan will be a new credit account, however, your average account age may drop a bit along with your credit score to start.
Here’s How Debt Consolidation Might Improve Your Credit
The good news is that it’s not all doom and gloom when it comes to consolidating your debts. In fact, there are at least two ways that debt consolidation can help your credit:
1. The Loan Can Improve Your Credit Utilization Ratio
Credit utilization is calculated by dividing the credit you’ve spent over the total amount of credit that you could spend. By most estimates, you want this number to be sitting at about 30 percent or less. A debt consolidation loan has the net effect of increasing your credit limit while keeping your balance more or less the same.
If you’re able to keep most of your credit accounts open, a debt consolidation loan can improve your credit score by lowering your credit utilization ratio.
2. You Can Use Your Loan to Further Establish Your Payment History
Remember that list of five credit-impacting factors that we talked about earlier? Payment history accounts for over a third of that score because it’s the factor that answers the number one question that lenders are trying to answer when they assess loan applications:
“Will this borrower be able to pay us back?”
If you take out a debt consolidation loan and you make your payments on time each month, you can build up your payment history and improve your credit score in one fell swoop.
Do Debt Consolidation Loans Hurt Your Credit?
When you’re drowning in money problems, debt consolidation loans can feel like the equivalent of being thrown a financial life jacket. But as with any personal finance tool, it’s important to do your due diligence.
In this case, the answer to the question “Do debt consolidation loans hurt your credit?” is “They can.”. But in the long run, you should be able to see your credit score go up as you continue to plug away at your debt.
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