Does Debt Consolidation Harm Your Credit score Rating? -The Phenix Group
There are tough times. In the face of constant economic change, we see people struggle to pay bills and get into debt. And if you are in debt, the search for a concrete solution to get out of it faster remains in your head.
In search of a solution, you may have heard of debt consolidation. But before proceeding with this decision, it is important to understand how it works and what impact it will have on your creditworthiness.
Get all the details right here.
What is Debt Consolidation?
Debt consolidation, often mistakenly referred to as debt settlement (it’s not the same thing), is the process of consolidating multiple high-interest debts into a single monthly payment and applying for a personal loan to pay them off.
Most people apply for debt consolidation through their credit unions, credit card companies, or banks when the working relationship is excellent. However, if these institutions do not approve such loans, then you should explore lenders and private mortgage agencies.
How Does Debt Consolidation Affect Your Credit Score?
Debt consolidation can have both positive and negative effects on your credit score. It is important to consider these factors before proceeding with your plan.
Result in tough inquiries
When you apply for a loan to pay off your debt, your lender makes a tough query about your creditworthiness. Your creditworthiness – the tendency to repay the loan when approved – is strictly queried. Tough inquiries will affect your credit score, reducing it by 5 points.
Now, when you apply for debt consolidation from multiple lenders, they can thoroughly inquire about your credit information. But no worry. These tough inquiries will not affect your creditworthiness as long as they are within a 14 to 45 day period. Hence, these inquiries become a single one when your credit bureaus calculate your credit score.
Note that there are no tough inquiries involved in applying for a loan. Take a look at a lender’s website or brochure to see if you qualify for a no-hack loan. Some lenders require a gentle query (or pull) that won’t affect your creditworthiness.
Your credit utilization will change
Financial institutions and lenders are also interested in your credit utilization. This ratio is the percentage of the available credit that you will draw on at any given point in time, and it usually makes up around 30% of your FICO score.
Now, if you have a credit utilization rate higher than 10% after debt consolidation, your credit score will lose a few points. If you choose to use a personal loan to pay off the remaining balance, the percentage will go down and your credit score will improve.
You may be tempted to close your accounts
When people go through a debt consolidation process, they are prone to closing their old accounts after transferring a balance. When you think about it, hold onto that thought. The average age of all of your accounts makes up about 15% of your creditworthiness. Hence, older accounts have better credit ratings.
Opening a new credit account and closing your old ones can lower their average age and increase credit utilization. These measures will significantly reduce your credit score. We recommend that you keep your old accounts (even those with zero balances) for your credit report after debt consolidation.
It improves your payment history
Keeping a record of the timely repayment of your debt will not affect your creditworthiness. In fact, it will improve in the long run. Your payment history accounts for about 35% of your creditworthiness.
So if you consolidate your debt into a single loan to pay off at lower interest rates, your credit score will improve significantly.
Pros and Cons of Debt Consolidation
Debt consolidation has several advantages and disadvantages. Let’s take a look at them:
- Optimizes your finances. Combining multiple debts into a single loan makes it easier for you to pay them off. You don’t have to worry about numerous payments or interest. It also reduces the likelihood of late payments.
- Lower monthly payments. After consolidating your debt, you will experience fewer debt payments as your payment schedule is spread out over a period of time.
- Have a fixed repayment schedule. When you consolidate your debts on a loan, you know how much you were about to pay each month and when your last payment will be. You don’t have to worry about random increases in your repayments.
- Boost your credit score. Debt consolidation leads to tough inquiries that will affect your credit score. However, if you repay your loan in a timely manner, your credit score will improve. Your payment history is 35% of your creditworthiness. So a timely repayment will improve them in the long run.
- Additional costs. Some debt consolidation loans come with additional expenses such as bank transfer fees, closing costs, allocation fees, and annual fees.
- Possible rate hike. When your creditworthiness is insufficient to get competitive rates from lenders, you can repay your debt at a higher rate.
- You risk missing out on payments. If you miss payments on a debt consolidation loan, your credit score will be massively affected. You also run the risk of paying additional fees.
- It won’t solve bad financial habits. Even if you consolidate your debt, it will not resolve the inherent financial behavior that got you there in the first place. Hence, it is important to practice reasonable financial behavior in order to limit unpaid debts.
Here’s how to consolidate your credit cards without compromising your creditworthiness
If you want to consolidate your debt without affecting your credit score, try these alternatives:
Contact a nonprofit credit counseling agency
You can sign up for a debt management plan with a nonprofit credit counseling agency. They can help you create work plans to alleviate your challenges, budget your finances, and work with your lenders to set up payments. Instead of paying your various lenders, you would just have to make one monthly payment to the agency, which then pays your lender.
Transfer of credit card balance
Another option is to transfer all of your current balance to a new credit card with an APR of zero. It makes it easier to repay all balances without interest.
You’ll likely pay a transfer fee of up to 5%, but it’s much better than taking out a personal loan.
You can still pay the debt yourself if you create a manageable budget. Cut down on unnecessary expenses and channel the funds into your repayment plans.
Take out a 401 (k) loan
A 401 (k) loan withdrawal will not appear on your credit report. Hence, these loans do not affect your creditworthiness.
Tips on How You Can Not Tackle Your Credit Score With A Consolidated Plan
While repaying a loan on a consolidated debt, there are a few tips that you should be practicing to avoid getting your credit score badly affected. They include:
Avoid taking out another loan during this time
You shouldn’t apply for another loan while you are repaying a consolidated loan to a lender. It would involve a hard query that would affect your credit score and lower your credit score.
Avoid closing your older credit accounts
Don’t close your older accounts as the average age of your accounts is around 15% of your creditworthiness.
Maintain a great financial habit
Maintaining excellent financial conduct will ensure that your loan will be paid back on time for your consolidated debt.
Final thoughts on the pros and cons of credit consolidation
Debt consolidation goes a long way in helping you pay off your debts faster. You don’t have to worry about different interest rates and payment dates. It also helps you budget better before the payment date and improve your credit score in the long run.
However, debt consolidation brings hard inquiries, additional fees, bad credit if you miss payments, and higher interest rates if you already have bad credit. It is recommended that you take important steps to pay off your loan promptly if you choose to do so. Do you have your debt behind you and want to improve your creditworthiness? Get A Free Consultation From The Phenix Group.