The best way to consolidate debt without hurting credit
With record levels of debt and historically high interest rates, Americans are starting to feel the pinch. If you are reading this, you are likely one of them.
The good news is that relief may be in sight.
By consolidating, or combining, your existing debts, you can obtain a more favorable interest rate and lower your payments. Not only that, merging debts makes debt management much simpler.
Over the next few minutes, you'll learn the ins and outs of consolidation and the best way to consolidate debt without harming your credit.
How debt consolidation works
Debt consolidation is a strategy typically—though not exclusively—used by people struggling with debt. While the exact process can vary, it usually takes the following steps:
- Evaluate debt: The first step is to take stock of your financial picture. This involves listing all outstanding debts, interest rates, and corresponding monthly payments.
- Secure a loan: To consolidate debt, you must be approved for a new loan. This loan will typically be from a new lender for the total amount of your existing balances. For example, if you had three debts of $500 each, the consolidation loan would be $1,500 (3 x $500).
- Cover existing debts: Assuming you’ve been approved, the new loan proceeds are used to pay off existing balances. Once complete, you no longer owe money to these creditors. Instead, you’re left with a single monthly payment.
- Manage new obligation: You’re now responsible for paying off the new debt each month. Ideally, this new loan will charge less interest than you incurred on the previous debts. The new debt may have a longer term, which can also reduce monthly payments, making them more manageable.
Debt consolidation pros and cons
|Consolidation often saves money over the life of the loan.
|Debt consolidation may include fees.
|It provides peace of mind through predictable payments.
|If using a secured loan, you will have collateral risk (i.e., risk of losing an asset tied to the loan should you default).
|It simplifies debt management by combining obligations.
|Consolidation can lead to larger interest payments over the life of the loan if you extend the term.
Consolidation is not debt settlement
Consolidation can sometimes be confused with settlement. While they’re both debt reduction strategies, that’s where the similarities end.
Debt settlement is when a borrower (or a third-party working on their behalf) negotiates with a creditor to pay a lump sum lower than the current balance. Creditors only accept this settlement if they believe it provides the best outcome.
With consolidation, existing creditors still receive the entire outstanding debt. With a settlement, they walk away with less than initially agreed upon.
As a result, debt settlement is considered a more severe option than consolidation. Typically, you might consider settlement only after attempting - and failing - at consolidation.
How does debt consolidation impact your credit?
Debt consolidation can both positively and negatively impact your credit score. However, if used appropriately, it will improve your creditworthiness over time.
How consolidation can hurt your credit
- Hard inquiries: Applying for a debt consolidation loan will likely require a hard inquiry into your credit. This action can temporarily reduce your score by 10 points.
- Closing old balances: Closing old debts, like a credit card, can reduce the age of your credit history and potentially lower your score. Roughly 15% of your credit score is graded based on the age of your debts. The older the debts, the better.
- Default: It’s entirely possible you can’t make payments on the new consolidation loan. Of course, this, too, can harm your credit.
How consolidation can help your credit
- Simplified payments: By reducing your debts to a single balance, you’re less likely to miss a payment. Making timely payments is critical to building healthy credit. In fact, your payment history accounts for 35% of your entire credit score.
- Faster debt reduction: You can clear the principal balance faster if your loan includes a lower monthly payment. This is viewed favorably by credit rating agencies.
- Lower credit utilization rate: All else equal, using less debt than you have available is helpful to your score. For example, you can reduce credit utilization by consolidating credit cards. This can drive huge improvements in your credit health since upwards of 30% of your score is derived from your utilization rate.
- Avoid delinquencies: Consolidation may be your best option to avoid missing payments.
Debt consolidation alternatives
Perhaps you’re looking for an alternative to debt consolidation that won’t impact your credit score—even temporarily. Here are some examples of how to get out of debt without ruining your credit initially:
- New budget: For some people, a revised budget is the best place to start. Evaluate your current financial status and habits. Look for opportunities to reduce expenses so you have more money to cover monthly obligations. Consider using a popular budgeting framework, like the debt snowball method.
- Credit card balance transfer: If you have reasonably healthy credit, you can transfer your credit card balances to one with a better rate. Issuers often offer favorable introductory promotions, like 0% APR for 12 months. This can be a powerful strategy for tackling unruly debts.
- Family and friends: While it’s not an option many want to pursue, receiving financial help from family or friends can be an effective way to climb out of debt without impacting your credit.
- Credit counseling: Services exist that can help guide you through debt management. In many cases, non-profit organizations offer these services free of charge.
When should you pursue debt consolidation?
Consolidation is most commonly sought by people struggling to cover debt payments. If you’re over your budget, it can be one of the best relief options free of long-term repercussions.
But consolidation isn’t just for those struggling financially.
It can also be a prudent move for those with high-interest debts looking for a better rate. It may also make sense if you want to simplify your debt management and cash flow.
While consolidation can initially lower your credit score, it’s essential to remember it’s temporary.
Over time, consolidation provides debt relief without hurting credit. As long as you don’t require another immediate loan, like a mortgage, consider taking advantage of this effective approach.