Manage Money

8 min read

September 07, 2020

Can a Debt Consolidation Loan Hurt (or Help) Your Credit Score?

Exploring the right strategy to consolidate debt without impacting credit scores

Interest rates at all-time lows. So, paying off your high-interest debt with a low-interest debt consolidation loan may be a smart move, especially if you’re only making minimum payments on credit cards or other bills. Debt consolidation loans can be used to pay for medical and credit card bills, student loan payments, and even other loans that you secured at a higher rate.

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How Do Debt Consolidation Loans Work?

Debt consolidation allows you to merge several unsecured debts into one low monthly payment at a lower interest rate. That’s the promise, but unfortunately, it’s not always what happens. That’s because debt consolidation loans are offered by lenders or creditors, and rates and terms will likely depend on your credit score and credit history. Even if you qualify for a low-interest loan, there’s no guarantee the rate will stay low. Besides, debt consolidation loans often extend the term of the loan, so you may end up actually paying more in the long run.

That said, debt consolidation loans can be a good thing if you’re up to your ears in debt, you’re paying unreasonably high interest, or you just can’t make all your payments. Even with extended terms, your one monthly payment will likely be much less than multiple payments at a variety of interest rates.

Why Consider a Debt Consolidation Loan?

It’s not uncommon to have many debts – credit cards, medical bills, student loans – all accruing interest charges. For instance, credit cards can carry double-digit interest, making it easy for card balances to spiral out of control.

It can also be difficult to keep track of multiple due dates, not to mention wondering each month if you have the money in the bank to cover each amount owing. If you fall behind on your payments, it can hurt your credit score, and you’ll rack up unwanted fees and late charges.

Another advantage of a debt consolidation loan is that it is a good way to pay off everything you owe. That’s because the loan has a predetermined payoff date. You make monthly payments, and at the end of the term, your debt is paid in full.

Pros and Cons to Debt Consolidation Loans

Using a debt consolidation loan to manage your debts can have both positive and negative consequences.

Pros of Debt Consolidation Loans

  • A lower interest rate means more of your payments are going toward your principal balance each month, so you’re making a bigger dent in your total debt.
  • You make one monthly payment rather than several payments, which makes it easier to stay on budget.
  • Simplifying multiple payments into one payment makes it more difficult to accidentally miss a due date.
  • There's the potential for both a lower interest rate and lower monthly payments than you're paying now.
  • Consolidating your debt helps you pay off older debts, which can raise your credit score over time.

Cons of Debt Consolidation Loans

  • Because with a debt consolidation loan you make only one payment, you might be tempted to spend more.
  • You might not always get a better interest rate, or the rate might not always stay the same over the term of your loan.
  • Most debt consolidation loans are secured, so you may lose your collateral if you default on your loan.
  • The term of your loan will likely be longer, so it will take you more time to pay off your debt.
  • Most loans charge some fees, like processing or origination fees, but some debt consolidation loans come with higher than normal fees and charges. It pays to shop around.
  • Initially, your credit score will take a hit. But, it is a short-term effect and your score should improve over time.

Will Debt Consolidation Loans Affect Your Credit Score?

Debt consolidation can go a long way in helping you get your debts under control. But, there are drawbacks to consider as well.

When Debt Consolidation Helps Your Credit Score?

  • Taking on more debt to pay off debt is never isea. But when done right, a debt consolidation loan can actually help your credit score.
  • A positive payment history makes up about 35% of your credit score, so by making your one payment on time every month, you can raise your score over time.
  • The amount you owe, or your total debt, is what makes up your credit utilization ratio. So, paying off your credit cards (but keeping them open) lowers the total amount you owe compared to your available credit. That’s good for your score.
  • Your credit mix, or the types of credit you have, accounts for about 10% of your credit score. Adding a loan to your revolving debt mixes things up and can raise your credit score.

When Debt Consolidation Hurts Your Credit Score?

If you’re not careful or you don’t shop around to find a helpful lender or creditor, a debt consolidation loan can hurt your credit score.

  • When you apply for new credit–a loan or credit card–your credit score takes a hit. For most people that can mean an impact of between one and five points off your credit score according to FICO. If you’re dangling on the edge between good and fair credit, a few points can mean the difference between a low-interest rate and a higher interest rate on your debt consolidation loan.
  • Every credit inquiry remains on your credit score for two years, but your FICO score is only impacted for one year.
  • The older your credit accounts, the better. It shows credit reporting agencies you can make your payments and makes up your credit history. Adding a new loan brings the average age down, which can lower your credit score - at least temporarily.
  • If you’re late 30 days or more making your payment, your credit score will suffer.
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Alternatives to Debt Consolidation Loans

Home equity loan. If you own a home, you might consider a home equity loan or HELOC (home equity line of credit) to pay off debt. Equity is the current value of your home, less what you currently owe. But beware, if you default on your loan or line of credit by falling beyond on your payments, you could face foreclosure.

Balance transfer credit card. If most of your debt is credit card debt, you might think about transferring balances from higher interest cards to a 0% APR card. Sometimes, 0% interest is only good for a promotional period, but it might give you enough time to get your head above water.

Personal loan. Most short-term personal loans have higher interest rates than home equity loans. However, the loan isn’t secured by your home.

Debt management. If you’re unsure about another loan, and your credit cards are maxed out, you may want to sit down with a credit counselor who will create a plan to manage your debt. Rates for this service vary, but it may be worth a few bucks to get your financial future on the right track.

Bottom Line

Most debt consolidation loans have a low-interest rate and extended repayment terms. Some come with risks and fees, and you may be in debt longer, but they are a great option if you’re bogged down with multiple payments at high-interest rates.

There are alternatives to debt consolidation loans, but not all of them work for everyone. The best advice is to create a plan, develop a budget, do your homework by shopping for a credible lender, and then pay off your debt and focus on saving.

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Kathryn Pomroy
Kathryn Pomroy is a journalist and writer specializing in personal finance, consumer banking, credit cards, and loans. She has written for LendingTree, Money Crashers, Quickbooks/Intuit and Bankrate.

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