Debt consolidation is a common financial strategy used by people struggling to manage their finances. It is, in a sense, a means through which you can pay off multiple debts as a single loan. While most consumers think of such a move as being positive, it does have certain downsides.
While debt consolidation can help you reduce your stress levels and save money, it’s important to understand its possible negative effects on your credit score before deciding to pursue it. In order to help you weigh the pros and cons of debt consolidation, we created this guide containing everything you need to know about this strategy.
What is debt consolidation?
Debt consolidation is an option that allows you to pay off all your debts at once rather than paying them in installments (as if they were individual loans). It combines two or more debts into a single, lower-rate loan. When you consolidate your debts, you combine multiple payments into one. This makes managing your finances much simpler.
What are the different types of debt consolidation?
Debt consolidation comes in several different forms. Below are the four main types of debt consolidation:
- Credit cards: You can choose between a new credit card with a low introductory APR, or an existing card with a high APR.
- Debt consolidation loans: If you have too much debt and cannot afford to repay it all right now, consider consolidating your debts. Consolidation allows you to save money on interest charges, and make one payment instead of paying off each individual creditor.
- Home equity lines of credit (HELC): Your home is probably worth more than your mortgage. By tapping into the equity in your house, you can borrow against the value of your property.
- Student loans: You can consider consolidating your federal student loans if you haven’t already repaid them. However, bear in mind that consolidating private loans may not be possible.
Why consolidate your debts?
If you have multiple credit card accounts, loans, or student loans, it can be difficult managing all those bills. A consolidation loan can help you simplify your finances and save money. You don’t have to worry about paying off multiple accounts each month; instead, you’re making just one payment to cover all of them.
Below are just a few advantages of debt consolidation:
- Lower interest rate
- Lower monthly payments
- A clear end date
- Only one payment per month
- Only one lender
How does debt consolidation work?
Debt consolidation is similar to paying off multiple credit card debts by transferring them onto one card. Instead of having several different bills to manage each month, and multiple different outstanding balances, you simply make one monthly payment to a single creditor. This method reduces the number of accounts you’re responsible for managing, so it makes sense financially.
What does debt consolidation do to your credit score?
When you consolidate debt, you’re basically pulling several levers at once that affect your credit scores. You might see some short-term drops in your credit scores, and think that you are accumulating poor credit when you take out loans or try to open up new credit cards. However, the long-term benefits of debt consolidation outweigh those dips, and there is a good chance that you will come out with excellent credit at the end of it all.
How debt consolidation positively affects your credit
Debt consolidation loans can both positively and negatively affect your credit report. Regardless of whether you have a good or bad credit history, a consolidated debt management plan can change things quickly.
Lower credit utilization
Credit utilization is a big part of your credit score. In fact, it accounts for 30% of it. Therefore, if you want to maintain good credit, you need to ensure that you are not using up all your available credit. If you’re carrying too much debt, consider consolidating it. By doing so, you open yourself up to having more money to spend elsewhere, thereby increasing your available credit. You may not notice any immediate difference in your credit score but over time you should see an improvement.
Faster debt payoff
Your ability to repay your debts depends largely on your ability to control costs. Consolidation allows you to cut back on certain types of expenses such as high-interest rates and late fees, thereby helping you save money and ultimately pay off your debt more rapidly. Moreover, this additional money allows you to make timely payments, which are extremely beneficial, as you will quickly be able to catch up on your outstanding payments, and pay off your single loan over a shorter period of time.
When you consolidate your debts, you are far more likely to make your payments on time. This is because you will only need to think about paying off one debt load every month. You will also build a good track record with your payment history, which will have positive repercussions. Making payments on time improves your credit score over time and also eliminates the chances of creditors charging you for late payments.
How debt consolidation negatively affects your credit
Debt consolidation can also negatively affect your credit score. Here are a few ways in which you could see your credit score negatively affected through debt consolidation.
Increased credit inquiries
Every time you apply for a mortgage, car loan, student loan, personal loan, or any type of credit, you’ll likely incur a hard inquiry with credit bureaus. These inquiries count towards about 10 %of your credit score. If you take out five loans within six months, you may see a significant dip in your credit scores. Before consolidating your debts, make sure your credit score is high enough to support the amount of debt you plan to carry. You can find out your credit score online.
Increased credit utilization
Although it is possible that consolidating your debt could lower your credit utilization, there is also the chance that it could raise it. This is because, if you take out a new loan or credit account to consolidate, and then close down your original credit lines, you could cause your credit utilization rate to rise. Your available credit drops, which lowers your credit score. However, if you keep your old credit lines active, you’ll have a higher credit score and fewer opportunities to get into trouble.
Lower age of credit
New accounts can lower the age of your credit accounts by lowering your credit utilization ratio. Your credit score also depends on how much debt you carry, and how old your oldest credit account is. So, if you’re carrying high balances on older cards, you’ll pay interest on those debts for a longer period than someone who pays off their entire balance every month. It’s worth noting that closing an account does not necessarily mean that you won’t ever use it again; just make sure you don’t close it before paying any outstanding bills.
Debt consolidation services
Consolidating or reconstructing your debt is often the best thing to do in order to get your credit balance back to normal. At Refinancement Hypothecaire, our financial experts and credit counselors are here to help you find the best solution to deal with your loans and debts. We are committed to helping you find a solution that works for you.