Most people pursue debt consolidation to reduce interest, but it also has the potential benefit of boosting their credit as well. Reducing the amount of debt you have relative to your available credit should have a major, positive impact on your score. Depending on how you go about it, though, the process of consolidating debt can also cause your score to dip.
Paying off debt a worthy goal, but before you pick a strategy, know which parts may hurt your credit.
When you apply for a new line of credit, whether it’s a card or a loan, you’ll trigger a credit inquiry. So if you’re hoping to consolidate your debt with a 0% APR balance transfer credit card or a personal loan, your credit score will take a hit. The good news? The effect on your score is small, and it only lasts for up to a year — and having more and different types of credit is a net positive where your score is concerned, as long as you manage it responsibly.
Your credit utilization ratio — that is, the amount of available credit you use — has a huge influence on your credit score. If you use a balance transfer to consolidate your debt, especially if you move multiple balances onto one card, your credit utilization ratio will suffer. That said, if you pay down the debt aggressively, this effect will be temporary, and having more available credit does help your ratio in the long run.
No matter your approach to debt consolidation — 0% APR balance transfer credit card or personal loan — you’ll experience a smaller dip in your credit score if you keep old accounts open after paying them off. Some debt management programs offered by credit counseling services will require you to close these accounts, however. This will lower your score, but keep in mind that it’s for a good cause.
Not following through with your plan
The biggest and most permanent way debt consolidation can hurt your credit is if you begin without a plan, or don’t follow through with the plan that you have. If you take out a loan but aren’t able to make payments on time, this will further damage your credit — and could leave you homeless, if you chose a home equity line of credit. And if you choose a credit card balance transfer, but don’t budget enough to tackle your balance by the time the introductory period ends, you may owe as much interest as you did before — or even more.
The bottom line
Debt consolidation is a positive step, as long as you’re prepared to do it right. But reaching a higher credit score isn’t always a direct trip. Fortunately, most of debt consolidation’s negative effects are temporary, whereas the positive effects of being debt-free are not. Still, if you’re boosting your credit for a specific reason, like applying for a mortgage, it’s a good idea to start the process long before you need a higher score.
Image via iStock.