Take a look at what debt consolidation is, how it helps you reduce your debt payments and how it impacts your credit score.
What is debt consolidation?
Instead of making multiple payments to various debts, a debt consolidation loan gives you the money to pay off all your loans at once. Then, you make a single payment every month, usually at a lower interest rate, till you pay off the consolidation loan. It’s that simple. There are two ways in which this works. One, through a personal loan, and two, through a balance transfer card.
Using a personal loan to consolidate your debt
This is a straightforward process. You apply for a personal loan and pay off all your existing debt. Then, you make a single payment every month to pay off the personal loan.
How it helps
- Compared to a balance transfer card you can get a personal loan with a much lower credit score.
- You can consolidate all your current debt into a single loan, making it easy for you to keep track of your monthly payments.
- It can improve your credit by adding to your credit mix. If you’ve been using only credit cards, a personal loan will help the credit mix since it is an installment-based loan.
- It helps reduce your credit utilization. That is, the amount of credit you use will reduce. And this helps improve your credit score.
Points to keep in mind
- If you fail to pay the installments on time, it will hurt your credit score.
- It may lead to more debt if you’re not careful.
- Some loans charge you a fee if you want to pay off the balance in advance (prepayment).
- Some loans charge a high APR for borrowing.
Using a balance transfer card to consolidate debt
How it helps
- If you have a very good credit score, you can an excellent rate of interest.
- No penalty or fee is charged if you choose to pay the balance in advance.
- Payments are highly flexible.
Points to bear in mind
- It usually requires a much higher credit score when compared to a personal loan.
- If you fail to pay off the entire balance before the offer date ends, you can be charged a higher rate of interest.
- Since your credit utilization is high, it will negatively impact your credit score.
What are your other options?
If you feel that neither of these two debt consolidation methods will work for you, you can check out the other options available.
401(k) loan
This loan does not impact your credit score in any way since it doesn’t reflect on your credit report.
Home equity loan
This is essentially a line of credit, so your credit score will be impacted due to the credit check. Also, you will get either a revolving account or a term or installment loan.
Debt management plan
Companies that offer debt management services can help you in negotiating your dues with your creditors. Applying for this plan doesn’t impact your credit score. But when you negotiate to pay a lower amount compared to how you actually have to pay, it can affect your credit score. In addition to this, your existing credit card accounts may be closed so that you don’t use any more credit till your debts are paid off. This will impact your credit score since the closure of credit accounts is a negative action for credit evaluation.
A debt consolidation loan will impact your credit score only to a small extent. Since a hard check is done on your credit history while applying for it, it impacts your score. But a personal loan can improve your credit mix. And if you pay all the installments on time, it will help improve your score. In general, responsible financial practices will help balance any negative impact on your credit score due to debt consolidation.
