With more and more American households accruing high balances on credit cards and loans, finding creative solutions to repaying debt is critical. One option when you owe money to many creditors is a strategy known as debt consolidation. By consolidating your debt, you can organize your accounts in one place and often benefit from a lower-interest window in which to begin paying your balances.
However, debt consolidation is not without its drawbacks. Debt consolidation can hurt your credit score temporarily, though there are ways to minimize the effects.
How does debt consolidation work?
Debt consolidation is the process of taking multiple loans and refinancing them into one loan with a new lender. There are multiple ways to consolidate your loans. The most popular way is to take out a personal loan and use those proceeds to pay off your other debts, but some consumers prefer to use home equity loans or HELOCs.
No matter which type of loan you choose, the process is largely the same. You’ll start by comparing interest rates among a few lenders to see which one offers you the best deal, and you’ll apply for enough money to cover your existing debts. Once you receive your loan funds, you’ll pay off your debt and begin making payments on your new loan.
How debt consolidation can affect your credit
Taking out a debt consolidation loan can either positively or negatively impact your credit, depending on a few factors. Here’s what you should be aware of.
Hard inquiry is performed
When you apply for a debt consolidation loan, the lender will perform a credit check. This will result in a hard inquiry, which could lower your credit score by 10 points. Hard inquiries will only affect your credit score for one year.
Credit utilization may decrease
If you have a large balance on a credit card, you may also have a high credit utilization ratio. This is calculated by dividing your current card balance by your total credit limit. If you have a credit utilization ratio greater than 10 percent, you may see a ding on your credit score.
However, if you pay off that balance with a personal loan, the utilization percentage will drop and your credit score will improve. The credit utilization ratio makes up 30 percent of your credit score, so it’s an important aspect of your credit.
Closed accounts may hurt your score
The average age of your credit accounts makes up 15 percent of your credit score, with a higher age being better for your score. When you open a new account, the average age of your credit history will decrease. If you close any old accounts after consolidating, that will also lower the average age of your accounts.
Thankfully, there are strategies to get around this. If you have old credit cards with high interest rates, you consolidate that debt using a new card with a lower interest rate. The new card may temporarily ding your credit score, but you can counter those effects by keeping all of your old cards open — even if you never use them.
When it makes sense to consolidate your debt
The most common reason to consolidate your debt is to save money on interest. If you can consolidate your debt and get a lower interest rate, you could save hundreds or even thousands of dollars in total interest.
Another popular reason to consolidate debt is to simplify your monthly payments. If you struggle to pay your bills on time because of differing due dates, consolidating could make it easier to manage your finances.
The smartest way to consolidate your debt
The most efficient strategy to consolidate your debt starts with making a list of all of your current loans and credit cards. Include the total balance, interest rate, minimum monthly payment and total remaining payments.
Next, decide what kind of debt consolidation option you’d like, whether that’s a personal loan, home equity loan or balance transfer credit card. You should get quotes from multiple lenders and compare APRs, terms and total interest paid.
Make sure to apply for these loans and credit cards within a two-week span to avoid multiple hard inquiries on your credit report. Once you have all of your offers, you can compare them with this debt consolidation calculator to see which lender you should choose.
3 alternatives to debt consolidation loans
If debt elimination is your goal but you’d rather not take out a debt consolidation loan, there are a few alternatives you can consider.
1. Debt management plan
If you feel overwhelmed by debt and need outside help, you can sign up for a debt management plan through a nonprofit credit counseling agency. Instead of making payments to your lenders directly, you’ll make one monthly payment to the agency, which will then pay your providers.
2. Credit card balance transfer
Transferring your current credit card balance to a new card with 0 percent APR may save you more money than taking out a debt consolidation loan. For example, if you get a 0 percent APR offer for 18 months — and you can repay the balance within that timeline — you won’t owe any interest.
You may have to pay a balance transfer fee of 2 to 5 percent, but that will still likely be less than if you took out a personal loan.
3. Budget overhaul
If you don’t want to go through the hassle of applying for a debt consolidation loan, you can still pay off the debt on your own. Try to create a realistic budget and focus on debt payoff. See where you can cut expenses and put that money toward your debt. If you get a raise or a windfall, add it to your loans.