If you’re struggling to pay your credit cards or any other high-interest debt, your credit score is at risk. Perhaps you’ve already seen it drop. But you may be able to quickly improve your credit, and even lower your monthly payments with one (relatively) simple strategy: debt consolidation. Debt consolidation is when you pay off existing debt with a new loan. Ideally, the new loan has a lower annual percentage rate (APR), but that’s not always essential to make it worthwhile.
We’ll explore how it works, how it can help your credit, and how to get a debt consolidation loan if you have bad credit.
How debt consolidation impacts your credit
When you consolidate debt, you do a few things that impact your credit score and will be noted on your credit report:
- Apply for a new loan.
- Take out a new loan.
- Pay off one or more existing accounts.
Each of these has an impact on your credit report and score. Though the biggest impact will be determined by how well you manage the new loan.
How it can help
Generally speaking, and if managed responsibly, a debt consolidation can mean big gains for your score, especially if you’re consolidating credit card debt. These factors generally have the largest positive impact on your credit score.
Improve payment history
The most important factor in your credit score is your payment history, accounting for 35% of your score. Any late payments hurt this part of your score — and the later payments are, the greater the damage. Another feature of payment history is how much you owe on delinquent accounts. If you’ve been struggling to make minimum payments and have seen your balances rise and your credit score drop, your payment history is probably why.
Note
If you already have late payments, it may be better to consolidate now before your score takes an even larger hit, which could make it harder to qualify for a debt consolidation loan.
While you won’t be able to undo late payments overnight, consolidating debt for a lower monthly payment could help improve your payment history going forward and steadily increase your score.
Decrease credit utilization/increase available credit
The second most important factor in your FICO credit score is “amounts owed,” which contributes 30%. A significant piece of amounts owed is your credit utilization, or how much credit you have available relative to your credit limits. When you have little credit available on your cards, meaning they’re nearly (or are) maxed out, your credit utilization is high and your available credit is low. That’s not good for your credit score.
For example, if you owe $15,000 across two credit cards, and have a credit line of $20,000 (across both cards), your credit utilization would be 75%. But if you pay that off with a debt consolidation loan, your credit utilization would decrease to 0% across those two cards, almost overnight. That can mean quick and significant gains in your credit score. The trick is you have to keep the accounts open — so that your available credit remains high — without racking up another high balance that could undo your gains.
Learn More: Should I Pay Off Debt or Save?
How it can hurt
Generally speaking, the credit gains you can make far outweigh any credit score losses if you responsibly manage the new loan and payment. But here are a few things that could drag your score down, especially initially.
- Hard inquiry: When you apply for a loan, the lender conducts what’s called a hard inquiry on your credit report. This doesn’t usually have a major impact on your FICO score, but it can lower it — usually by no more than five points — for up to one year.
- Length of credit history: Whenever you open a new account, it brings the average age of your accounts down. This will improve over time, as the new account ages. Length of credit history makes up 15% of your score.
- Higher credit utilization, in some cases: If you use a balance transfer credit card to pay off an installment loan, like an auto loan, you could decrease your available credit, which could decrease your score.
How debt consolidation works
To consolidate means to bring together or combine, and that’s what a debt consolidation loan does. It combines multiple debts into a single loan, with a single monthly payment to manage, and a set repayment term — usually a number of years. You can consolidate different types of debt, such as credit card debt, medical bills, and other personal loans.
Learn More: How Does Debt Consolidation Work?
Tip
You can also use a debt consolidation loan to refinance a single debt to get a lower interest rate and/or lower monthly payment.
Here are some of the main advantages to debt consolidation:
- Lower monthly payments: You can reduce your monthly payment by getting a lower rate than the one(s) you’re currently paying or by choosing a repayment term that lowers your monthly payment. (A longer repayment term usually equates to lower monthly payments, though it generally means more money paid in interest overall).
- Lower APR: The most commonly used loans for debt consolidation — personal loans and home equity loans — have much lower rates than credit cards, on average. For instance, a 2-year personal loan had an average rate of 12.33%, according to the Federal Reserve, whereas credit cards had an average rate of 21.86%.
- Replace multiple payments with one single payment: Reducing the number of payments you need to make can help prevent missed payments and late fees.
- Replace variable interest rates with a fixed interest rate and payment: Credit cards have a variable interest rate that can change with market conditions. Loans used to consolidate debt typically have a fixed interest rate with a monthly payment that won’t change.
- Establish a set repayment term: Debt consolidation loans tend to be installment loans, which have a predetermined repayment schedule and period, after which the loan is entirely paid off. Credit cards are a type of revolving credit and aren’t built to have a defined payoff date.
- Improve credit: If consolidating makes it easier to afford payments and make them on time, that’s a big win credit-wise. But also important is the quick credit gain you can make by paying off multiple credit cards (if you’re consolidating credit card debt). More on all this below.
Types of debt consolidation loans
You can consolidate debt by transferring it to a credit card, in some cases, or with an installment loan that pays off your existing debt in one lump sum. You might make the biggest — especially initial — credit gains by using an installment loan to pay off debt. But you could get a lower initial interest rate with a balance transfer credit card.
Personal loan for debt consolidation
Personal loans can be an ideal way to consolidate debt, especially credit card debt. They can be easy to get — some can be funded the same day you apply — and have much lower interest rates than credit cards do, on average. Plus, you can choose a repayment term from one to seven years (with most lenders), which can help you customize a monthly payment that works with your budget.
Online lenders, banks, and credit unions offer personal loans for debt consolidation, and you can easily compare quotes by prequalifying with lenders before you apply. Prequalifying won’t hurt your credit score, and can give you an idea of the rates and loan terms you might qualify for. Plus, it only takes a few minutes. Not all lenders let you prequalify, but if you use a personal loan marketplace like Credible, you can compare multiple lenders in one place before choosing one to apply with. Formally applying for a loan is what will trigger the hard inquiry that will temporarily lower your credit score by a few points.
Once you’re approved for a debt consolidation loan, some lenders will route the money to your creditors directly — which could even shave 0.25 percentage points off your rate, depending on the lender.
Personal loan APRs range from around 6% (if you have excellent credit) to over 30% (if you have bad credit). But you may be able to apply with a cosigner or a co-borrower to lower your rate.
Good to know
The APR indicates the total cost to borrow money, and accounts for the interest rate and upfront fees, like an origination fee.
Learn More: APR vs Interest Rate
Credit card balance transfer
The lowest debt consolidation rates you can get could be via a 0% balance transfer credit card. The 0% rate is only temporary, but could last up to 21 months (or longer), depending on the offer, allowing you to skip interest rates for the duration. Note that you’ll usually pay a balance transfer fee between 3% and 5%, so it’s not free. But it can be the best way to consolidate debt if you can pay off the entire balance within the promotional period. After that time, the APR will adjust to the standard rate, which could be upwards of 30%, leaving you with a high, potentially unaffordable, monthly payment.
If you don’t have good credit, it can be tough to qualify for a credit card with a 0% introductory rate. But that doesn’t necessarily mean a 0% balance transfer is off the table. Check your current cards (especially any you don’t use much) for balance transfer offers.
If you can’t pay off the entirety of the balance you’d like to transfer within the promotional period, consider pairing it with another debt consolidation loan, like a personal loan. Transfer the amount you can comfortably pay off to the 0% balance transfer credit card, and pay off the rest with a personal loan.
Home equity loan
Aside from a 0% balance transfer offer, a home equity loan could offer you the lowest rates to consolidate your debt. You’ll need to have a home with sufficient equity to qualify — your current mortgage should be less than 80% of your home’s value — and you’ll need to be prepared for a relatively lengthy approval process. While debt consolidation with a personal loan or balance transfer can happen within days, it could take over a month to be approved for a home equity loan.
Learn More: Types of Debt Consolidation Loans
Important
These loans are secured by your home, so if you can’t make payments, you could risk losing your home.
FAQ
Can debt consolidation improve credit?
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Does credit card consolidation hurt your credit score?
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