Debt consolidation can help in lowering monthly payments and improve credit scores. However, the key to successful debt consolidation is to stick to a plan while paying down your debt.
Suppose you have high-interest credit card dues on many accounts. Making monthly payments towards these can be tough and there could be times when you can’t afford to spend on other things that you want.
In such situations, debt consolidation can prove to be a smart decision. However, before opting for it, let’s dig into some of the important aspects of debt consolidation and how it can affect your credit score.
How can You Consolidate your Debt?
The main objective of debt consolidation is to combine multiple credit or loan dues into a single fresh loan. Here are four ways to consolidate debt depending on the credit outstanding and savings of an individual:
- Balance transfer credit cards — Some credit cards, also known as balance transfer cards, come with introductory period offers under which the charges are low or no interest is charged on balances transferred to the card within a specific period. This helps to save on interest and allow fast progress in paying off the outstanding debt.
- Personal loans — A personal loan with a lower interest rate can also help in paying off higher-interest credit card balances. This can also be one way of paying off outstanding debt faster.
- Retirement account loans — A loan from a retirement account can also be used to consolidate and pay off outstanding debt. However, it is important to pay it back as per the retirement plan’s rules else there could be taxes and penalties.
- Home equity loan or line of credit – With a home equity loan or line of credit, homeowners can take out a loan by using their home as collateral. These loans generally come at lower interest rates as compared to credit cards or personal loans.
Addition Reading: The Pros and Cons of Credit Card Debt Consolidation
Why Should You Consolidate Your Debts?
Debt consolidation can help in saving your money. If your credit card debt charges a 20% or higher interest rate, consolidating it into a new credit card or loan that has a lower interest rate will help in saving your money. Estimate the rates for your specific debt to ensure that you can save beyond the fees you’ll pay towards balance transfers.
It can also help in simplifying your payments. If you have multiple accounts to manage, there are higher chances of making a mistake and miss a payment. Missed or late payments can negatively impact your credit scores, so consolidating them into one monthly payment can protect your credit score.
How Debt Consolidation Affects Credit Scores?
When you choose debt consolidation, you take charge of all outstanding at once and this can either help or harm your credit. Here is how your credit score can be impacted when you choose debt consolidation:
- New credit applications —Whenever you apply for a personal loan or balance transfer credit card, lenders will perform a hard inquiry and this can lower your credit scores by a few points. This will happen even before you have started working on debt consolidation.
- New credit account — A new credit account in the form of a credit card or personal loan can temporarily lower your credit scores. Lenders consider new credit as a new risk. Thus, your credit scores can take a temporary dip while taking out a new loan.
- Lower credit age— As your credit accounts age and reflect a positive history of timely payments, your credit score will rise. At this time, opening a new account can lower your average account age and therefore your credit score.
- Lower credit utilization ratio — Credit utilization is a measure of how much of the total available credit you end up using. This ratio may fall when you open a new debt consolidation account. This is because it increases your available credit. Lower credit utilization can help to counter some of the negative effects of new account opening.
- Better payment history — This may take some time, but if you make timely payments on your new loan you will see your credit scores rise back slowly. Your payment history has a heavy influence on your credit scores, hence, make sure to always pay on time.
Consolidating your debt into a fresh, low-interest loan can hurt your credit scores in the short term. However, with regular payments towards the consolidation loan, your credit scores will recover fast and can be in a good range in the long run. It will help in faster debt repayment and maintaining a sound payment history.
- How can debt consolidation hurt your credit score?
Consolidating debts into a single payment and making payments as agreed can boost your credit and help with budgeting. There are certain risks associated as well. Consolidating your debt can reduce your monthly payments, but it can also result in a temporary dip in your credit score.
- Do debt consolidation loans damage your credit?
Debt consolidation can raise your credit scores in the long term, provided you use it to pay off the debt promptly. You may also see a decline in your credit score in the short term.
- Can I continue to use a credit card after debt consolidation?
After consolidating your debt, you can keep your credit card accounts open. However, you must stop using all of them. The idea is to ensure that you maintain a zero balance on those credit accounts till the time your debt is repaid.
- How can I clear my debts quickly in India?
You can begin listing out all your outstanding debts in order of long-term commitments to short-term commitments. Begin by consolidating debt and paying off the larger chunk first.
- How long does debt consolidation stay on your credit report?
There is no fixed timeline, however, in most cases, it may stay for up to 7 years. This period is counted from the date that it is reported as settled.