Does Debt Consolidation Hurt Your Credit?

Debt consolidation may temporarily lower your credit score due to hard inquiries and changes in credit utilization, but consistent, on-time payments can help improve it over time.

Carrying debt, whether it’s through personal loans, credit cards, mortgages, or student loans, is common in America. And if you’re struggling to keep up with your payments, you’re not alone. The average household has more than $104,000 in debt as of July 2024. Consolidating your debt could help make paying off what you owe easier, but does debt consolidation hurt your credit? It can, though the effects are usually temporary.

In this post, discover how consolidating your debts can streamline your finances, boost your credit score, and set you on the path to financial freedom.

What Is Debt Consolidation?

Debt consolidation is the process of taking out a loan or a new line of credit and using the funds to pay off or dramatically reduce your current debts, ideally at a lower interest rate or with a lower monthly payment. This could help you pay off what you owe faster, get out of debt, and improve your total credit utilization ratio.

A key difference between debt consolidation vs. bankruptcy is that debt consolidation is for those with the financial means to continue paying off their debt without court involvement. And as you pay those debts off, you’ll be reducing your credit utilization ratio, which makes up 30% of your FICO® score. The lower it is, the easier it will be for your score to improve. 

There are several methods you can use to consolidate your debt. Here are some of the more common:

• Personal loans: These loans are typically issued by banks, credit unions, and online lenders. You can use the funds however you see fit, including consolidating your debt.
• Balance transfers: If you have credit card debt, you may be able to roll your current balance over to a new credit card, ideally with a lower interest rate. 
• Home equity loans: If you own your home, you may be able to borrow against the equity you’ve built in the home and use it to consolidate your debt. 
• Home equity lines of credit (HELOCs): HELOCs work similarly to home equity loans. You’re borrowing against the equity you have in your home, but instead of getting the money in a lump sum payment, you’ll instead have a line of credit tied to your home. 

Each debt consolidation method offers different benefits and potential downsides. Consider consulting with a loan officer to discuss your situation so you can find the best method for your needs.

How Debt Consolidation Affects Your Credit Score

Consolidating debt can impact your credit score in several ways. Here’s how.

The Hard Inquiry Affect 

Debt consolidation can both help and hurt your credit. When you consolidate your debt, your lender will typically perform a hard inquiry. These inquiries show up on your credit report and can temporarily cause your score to drop by a few points. However, once you get your debt consolidation loan and start paying off what you owe, you’ll decrease your credit utilization ratio and should see your score go up.

Changes in Credit Utilization Ratio

Credit utilization ratio refers to the total amount of your available credit that you’re using at any given time. When you carry a balance on your credit cards, your credit utilization ratio will be higher because you’re using more of your available credit. But when you consolidate your debt with a loan and use the funds to settle your debt, you’ll decrease your credit utilization ratio, helping you boost your credit score. 

Long-Term Impacts

Consolidating your debt can also have a long-term impact on your credit report and your credit score. When you use a debt consolidation loan to pay off what you owe, you could end up closing the original account. This could shorten the average length of your credit history, which could hurt your score in the long run.

But as long as you’re making payments on your debt consolidation loan on time each month, you’ll likely see an improvement in your score. You may want to sign up for automatic payments to reduce the risk of missing payments or making late payments.

Pros and Cons of Consolidating Debt

There are several potential benefits and disadvantages of consolidating your debt. Let’s take a closer look.

The Benefits of Debt Consolidation

• Simpler finances: Debt consolidation loans can give you fewer payments to keep track of each month. The fewer payments you have, the easier it is to make sure you’re paying everything on time.
• Potential lower interest rates: The best debt consolidation loans and products offer lower interest rates than the loans and credit cards you’re currently trying to repay. Lower rates could help you save money in the long run.
• Fixed payments: Many debt consolidation loans offer fixed interest rates. This means the interest rate on your loan won’t change over time, giving you predictable payments that are easier to budget for each month.

The Disadvantages of Debt Consolidation

• Potential damage to credit score: Applying for a debt consolidation loan may result in a hard inquiry which could damage your credit score. Missed payments on your debt consolidation loan could also cause your score to drop.
• Longer repayment terms: When you take on a new loan, you could have longer repayment terms. This may give you a lower monthly payment, but it could also increase your out-of-pocket costs. The longer the repayment period is, the more you could end up paying in interest.
• Upfront costs: Most lenders will charge you fees for originating (creating) the loan as well as other administrative fees. The amount you’ll pay will depend on the lender. 

5 Ways to Consolidate Debt Without Hurting Your Credit

Though any loan or new line of credit could trigger a hard inquiry that hurts your credit score temporarily, debt consolidation could end up helping you in the long run. Here are some great debt consolidation options to consider when consolidating your debt.

Debt Consolidation Loans

Debt consolidation loans are loans specifically designed to help borrowers consolidate other debts. These loans typically have lower interest rates than credit cards which have an average rate of more than 20%. 

Pros	Cons
These loans simplify multiple payments by rolling them into one.	You may have to pay upfront costs like origination fees and loan closing costs.
Most debt consolidation loans offer fixed interest rates and predictable payments.	Lower credit scores often qualify for higher interest rates.
They often have lower rates than credit cards.	You’ll be opening a new loan, which could hurt your credit score.
You may be able to pay off what you owe faster.

Home Equity Line of Credit (HELOC)

Home equity lines of credit let you borrow against the equity you’ve built up in your home by paying down your mortgage. They work similarly to a credit card in that you’re able to borrow money from the line of credit and repay it over time. If you don’t borrow the maximum amount of the HELOC or repay what you owe, you can continue using the HELOC, just as you would your credit card, until the end of the term. 

Pros	Cons
You may qualify for lower interest rates compared to unsecured loans and personal loans.	The lender may take possession of your home if you default.
You could be eligible for tax-deductible interest payments.	HELOCs have variable interest rates that may go up over time.
There are typically no restrictions on how you can use the money.	You’ll have to pay upfront fees and closing costs.

Balance Transfer Credit Cards

Balance transfer credit cards allow you to roll the balance carried on one or more credit cards onto a new card, ideally with a lower interest rate. Many of these cards offer low or no-interest introductory rates, so you’ll only have to pay the principal on what you transfer. 

As long as you pay that amount in full by the end of the introductory term, you’ll avoid paying interest on the balances you transfer. This can save you money in the long run and help you pay down your credit card debt faster.

Pros	Cons
Introductory rates are typically low.	Interest rates can be high after the introductory period.
You’ll streamline your monthly payments by reducing the number of payments you have to make.	You’ll typically have to pay a balance transfer fee of 3% to 5% of the total balance you’re transferring.
Some cards offer rewards like cash back, miles, and rewards points.	You’ll need good credit to qualify for the best offers and rates.

Debt Management Plans (DMPs)

Debt management plans are a type of debt relief that allows you to repay what you owe at a lower negotiated rate. You may be able to negotiate a lower repayment amount, lower interest rate, or lower monthly payment, depending on your lender. You may also be able to work with a service to handle those negotiations on your behalf.

Pros	Cons
You could reduce the several different debts to one monthly payment.	Most debt management plans take three to five years to get you out of debt.
You may lock in lower interest rates, and creditors may waive their fees.	There are setup and monthly maintenance fees associated with using a service.
You’ll gain access to ongoing financial education and support to improve your money management skills.	You may need to stop using existing credit cards, which could impact your total available credit and may reduce your credit score.

Cash-Out Refinance

Cash-out refinances let you borrow against the equity you’ve built in your home, but they do so by letting you refinance your current mortgage. When you do a cash-out refinance, you get a lump sum of money based on the equity you have in your home, and you’re able to move your mortgage into a new home loan, ideally at a lower interest rate.

Pros	Cons
Cash-out refinance options often have lower interest rates than unsecured loans.	You’ll increase your overall mortgage debt and may extend the time it takes to pay off your home.
You could end up with a lower mortgage interest rate, saving you money over the life of the loan.	If you miss payments or default on the loan, your lender could foreclose on your home.
You may be able to deduct interest payments from your taxes. Consult with a tax specialist to see if you’re eligible.	Closing costs and fees can be high. You may pay between 2% and 5% of the loan amount in fees.

Best Practices for Consolidating Debt

Consolidating your debt can be a great option, especially if you’re looking at how to get out of debt. But there are some things you can do to help you improve your financial situation.

• Keep old accounts open: Though it’s tempting to close old lines of credit after paying off your balance, try not to. Keeping them open will maintain your average credit age, which could help you keep your score higher.
• Make all payments on time: Be sure to make all payments on time, whether you’re paying down a credit card or are working on a debt consolidation loan. Missed and late payments can hurt your credit score.
• Don’t open new lines of credit: Opening new lines of credit can cause your credit score to drop and may make it easier for you to take on new debt. Instead, focus on paying off your existing debt.

These tips are just the start. Think about how every action you take could impact your finances and your credit score, and you’ll be able to make decisions that work for your long-term goals.

Does Debt Consolidation Hurt Your Credit FAQ

Check out these frequently asked questions about debt consolidation.

Does a Debt Consolidation Loan Hurt Your Credit Score?

Applying for a debt consolidation loan will typically trigger a hard credit inquiry. This is how lenders check your credit score and gain an understanding of your financial situation. 

Unfortunately, hard inquiries can cause your score to drop by a few points every time. But the drop should only last for a month or two as long as you make regular payments on your debt consolidation loan and avoid taking on more debt.

Does Credit Card Debt Consolidation Hurt Your Credit?

It can. Just as with a debt consolidation loan, applying for balance transfers or personal loans to consolidate your credit card debt will usually trigger a hard credit inquiry.

How Long Does Debt Consolidation Hurt Your Credit?

It depends. If you apply for a debt consolidation loan or a balance transfer and make payments on what you owe without taking on more debt, you’ll typically see your score improve in a month or two. 

However, if you consolidate your debt and continue to charge more of your regular purchases to a credit card without paying it off, you may not see the positive impact of debt consolidation.

Is Debt Consolidation Right for You? 

Does debt consolidation hurt your credit score? It can temporarily, but as long as you stay on top of your payments and pay down your balance, it will help your credit score in the long run. 

Before you consolidate your debt, it’s helpful to see where you stand. Get your credit report card and check your score before deciding.

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