How to consolidate debt without hurting your credit
Key takeaways
Debt consolidation puts multiple debts into a single account to make your payments easier.
Debt consolidation can lower your credit score temporarily, but your score will improve if you make payments on time.
Other tools like debt management plans and bankruptcy can help you manage debt.
You’re not alone if you’re carrying large amounts of debt across multiple credit cards and loans. According to the Federal Reserve Bank of New York, total household debt reached $17.5 trillion in Q4 2023. Credit card balances stood at $1.13 trillion. TransUnion reported that the average debt per borrower was $6,360 as of Q3 2023.
If you owe a lot of money on multiple credit cards and loans, debt consolidation can provide a way out. Unsurprisingly, there’s also a lot of misinformation and confusion about the process. What is the best way to consolidate debt? Is debt consolidation bad for your credit? Does the process really work? What are the possible drawbacks?
Debt consolidation doesn’t get rid of your debt, but it can help you pay it off efficiently. You should weigh the pros and cons and know how it will affect your credit score to decide if debt consolidation is right for you.
What is debt consolidation?
Debt consolidation lets you to roll debts into a single account. This process can make your life easier. You can merge multiple monthly payments to different creditors and lenders into one payment to a single source. Depending on the method used, debt consolidation can also help lower your overall interest rate.
You can consolidate your debt in a few ways. How you decide to consolidate your debt can change how your credit score is impacted.
Personal loans
A personal loan gives you a lump sum, which you can use to pay off your multiple creditors and lenders. You then repay that loan in monthly installments over months or years.
Personal loans generally have a fixed interest rate. The interest rate you owe (and the amount of money you can borrow) depends on your credit score and the lender you choose.
Home equity loans or HELOCs
Home equity loans and home equity lines of credit (HELOCs) are secured loans that use your home as collateral:
A home equity loan is a second mortgage (at a fixed or variable interest rate). It gives you cash equal to a portion of the equity in your home.
A HELOC is a revolving line of credit similar to a credit card or credit line. You borrow what you need from the line of credit, repay it and use it again when needed. How much you can receive is tied to your home’s equity.
Balance transfer credit cards
A balance transfer credit card lets you move existing debt from various credit cards to a single card. These specialized credit cards can offer a low or zero-introductory annual percentage rate (APR).
Does debt consolidation hurt your credit?
Debt consolidation can negatively impact your credit score. Any debt consolidation method you use will have the creditor or lender pulling your credit score, leading to a hard inquiry on your credit report. This inquiry will decrease your credit score by a few points.
However, this credit score decline is temporary. Making consistent, on-time payments on your HELOC, personal loan or balance transfer credit card will help boost your overall credit score over time. Credit bureaus like to see an on-time payment history. Those payments make up 35% of your overall credit score with FICO.
On the other hand, making off-and-on payments or completely missing payments are good ways to make a mess of your credit score.
Pros of debt consolidation
Managing your payments through debt consolidation can offer plenty of benefits, including:
Faster debt repayment: The main advantage of consolidating debt is combining multiple monthly payments into a single monthly payment. This allows you to direct your payments to a single source. You won’t be paying many minimum payments. This process can help reduce your debt more quickly.
Lower interest rates: Depending on your credit score, you could find yourself paying a lower interest rate through a debt consolidation loan or credit card transfer. A lower interest rate means more money stays in your pocket. That extra cash could help you pay off your debt faster.
Cons of debt consolidation
It’s also important to understand the downsides:
Upfront costs: That personal loan or HELOC doesn’t come for free. You’ll have loan origination, application fees or closing costs if you’re using home equity. Balance transfer credit cards might also charge fees. These costs are either fixed or a percentage of the loan.
Longer payoff terms: You could pay less per month with a debt consolidation plan. However, you might be paying this off over a longer time. If so, you might pay more in interest.
Fees if you can’t make payments: If you miss even one payment on a debt consolidation loan, you could be dinged with a late fee. If your payment doesn’t go through because of insufficient funds, you might get a return payment fee.
Damage to your credit score if you can’t pay: Once your payment is more than 30 days past its due date, your creditor or lender might report the omission to the credit bureaus.
How do you decide when debt consolidation is a good idea?
When considering a debt consolidation plan, it’s a good idea to consider a few important factors to decide if it’s going to work for you:
Your credit score: One goal of debt consolidation is to reduce the interest rate on your debt. The idea here is to pay a lower interest rate on a consolidation loan or balance transfer credit card than you currently have. This is doable with a “good” credit score, which is at least 670 (FICO) or 661 (VantageScore).
Your budget and financial goals: Debt consolidation could make your payment period longer. It can also provide a route to a specific, fixed monthly payment. This might be ideal if you’re working within a specific budget.
Your ability to repay: Don’t get a debt consolidation loan unless you’re 100% sure you can repay it. Missing payments could drive you deeper into debt, and missed payments drag down your credit score.
What are the alternatives to debt consolidation?
If you’ve realized you might not be a good candidate for debt consolidation, there are other options to help pay down your debt.
Debt management plans
Debt management plans are offered by nonprofit agencies that work with creditors and lenders to negotiate more favorable terms for you. You make one monthly payment to the agency, which then pays your creditors. These agencies also help you formulate and follow a reasonable budget.
Debt settlement plans
Through debt settlement procedures, you negotiate directly with your creditors to reduce your interest rates, monthly payments or both. You can take the reins and do this on your own, or you can have a debt relief company do much of the work for you.
However, be careful when considering working with a debt settlement company, which can be an expensive option. Furthermore, if you work with a scam company, you could also have more debt problems than you started.
Bankruptcy
If all else fails, bankruptcy can help with your debt problems.
On the upside, bankruptcy can cancel what you owe, helping rid you of overwhelming balances and calls from creditors. On the downside, bankruptcy means attorney fees and remains on your credit report for a long time, anywhere from seven to 10 years.
Bankruptcy should be considered as a tool of last resort, only to be considered if all other attempts to reduce your debt have been exhausted.
The bottom line
It’s important to understand that debt consolidation doesn’t get you out of what you owe. You still need to pay your creditors and debtors. However, debt consolidation can help you redirect your financial resources and pay debt down more efficiently.
The key is determining the best way to consolidate debt for your specific financial situation. Then, dedicate yourself to making on-time payments and sticking with the process. When used correctly, this process can help you successfully pay off lenders and credit card companies while improving your credit score over time.