In daily life debt is typically given a negative connotation, yet much of our everyday lives revolve around it. From consumer debt, to auto loans, to mortgages, debt can be a powerful tool for making larger purchases. When managed responsibly, the buying power that debt allows us may make it easier to buy things that once seemed unattainable. However, debt can sometimes become uncontrollable; debt consolidation is a viable option that may help alleviate its devastating effects. Continue reading to understand what debt consolidation means and its impact on your credit score.
What Does Debt Consolidation Mean?
Debt consolidation is when you combine multiple debts into one loan with one single payment per month. With debt consolidation, you can roll multiple high-interest debts into one single, lower-interest payment. Debt consolidation may benefit you if you’re planning to organize multiple debts with various interest rates into one monthly payment as part of a debt management plan.
Types of Debt Consolidation Loans
If you’re considering debt consolidation, there are two primary ways you can begin. The first way is by obtaining a credit card balance transfer with 0% interest. Once you obtain this credit card, you can transfer your debts onto it and pay the balance in its entirety during the promotional period.
You can also obtain a fixed-rate debt consolidation loan. With a debt consolidation loan, you can use the money to pay your debt off, then pay back the loan in installments over a set term. Unlike a balance transfer credit card, the interest rate on a fixed-rate debt consolidation loan does not increase after a promotional period.
Additional Ways to Consolidate Debt
Some additional (albeit risky) ways to consolidate your debt involve taking out a 401k loan or a home equity loan. A 401k loan can offer access of up to $50,000 from your retirement account with no impact to your credit score. A home equity loan may have a marginal impact on your credit score due to the detection of a large line of credit.
Taking a home equity loan involves borrowing from your home equity to consolidate debt. There is a great deal of risk involved in using your home as collateral, as it brings the risk of foreclosure if you’re unable to make your payments. You may also end up owing more than you borrowed if the value of your home drops.
A 401k loan allows you to borrow against your retirement savings. With a 401k loan, you may borrow up to half of your retirement account, a maximum of $50,000, for no more than five years. The main risk associated with borrowing a 401k loan to consolidate debt is the potential derailment of your retirement savings.
Negative Impact of Debt Consolidation on Credit Score
New Applications for Credit
Debt consolidation impacts your credit score in several ways. The first way is through the initial application for a personal loan or a balance transfer credit card. These applications require the lender to perform a hard inquiry into your credit history which may lower your credit score by a few points.
New Credit Accounts
Once you’re approved for a personal loan or balance transfer credit card, your credit score may be lowered due to the presence of a new credit account. As lenders may view new credit as a potential risk, your credit score may temporarily decrease due to a new account.
Decreased Average Age of Credit
Opening a new personal loan or credit card will result in your average account age decreasing due to the presence of new accounts. As a result, your credit score will see a temporary drop due to the decrease in your average age of credit.
Positive Impact of Debt Consolidation on Credit Score
Your Credit Utilization Ratio May Decrease
When you open a new debt consolidation personal loan or balance transfer credit card, your available credit will increase. This new account will cause a lower credit utilization rate which may counterbalance some of the negative effects of opening a debt consolidation account.
Your Payment History May Improve
Your payment history is the most influential factor in determining your credit score. Once you begin making payments on your debt consolidation account on time, your improved payment history can help make your credit score rise.
When Should I Consolidate Debt?
The decision to consolidate debt should come after careful planning and consideration. If your goal is to pay down debt quickly, then applying for a debt consolidation personal loan or balance transfer credit card may be in your best interest. One important thing to consider is a lower credit score may make it difficult to receive favorable interest rates for debt consolidation. This is why it’s important to take inventory of your current debt and credit score before taking steps to better manage your debt.