Perhaps you have a large amount of debt and have been wondering if debt consolidation is right for you. Before you decide to take the plunge and sign on the dotted line, you will want to consider how debt consolidation will affect your credit score.
Debt consolidation is simply combining all of your debt into one payment. This is done by obtaining a loan or opening a credit card account that will cover the total amount you owe. Once you receive the loan, you pay off your debt and then make one, often lower, monthly payment. It sounds easy enough, and it is, but you need to watch out. There are pros and cons that come with debt consolidation.
Cons of Debt Consolidation
First off, when you apply for a loan or new credit card to use to consolidate your debts, the bank or credit card company will make a hard inquiry to check your credit. This inquiry automatically decreases your credit score. Luckily, it isn’t a big hit, but it will have a small impact.
The second possible con of debt consolidation is how you decide to consolidate. If you plan on applying for a new credit card and transferring all of your debt onto the card, there can be issues.
Part of your credit score is based on your credit utilization. That is the total amount of debt you have compared to the total amount of credit available to you. For example, if you have a total of $5,000 in credit available to you and you have used $2,000 you have a ratio of 40 percent. The lower this number the better, and typically you want it below 30 percent.
So, if you open a new credit card, that does increase your available credit which is a good thing as your utilization ratio will be decreased. The issue is that once you move all of your debt to the one new card, that specific card will have a high balance which can cause your overall credit score to go down even though all of your other credit cards have zero balances.
Finally, if you then close your credit card accounts that have zero balances, your utilization score can go much higher which will, in turn, hurt your credit score.
Pros of Debt Consolidation
There are certainly pros to debt consolidation as well. First, if you decide to obtain a personal loan to pay off your debts, then you could see your credit score go up. That’s because your credit card balances will be reduced to zero without having one high balance, and your utilization ratio will be greatly reduced. Of course, you will need to keep those accounts open for this to have a positive impact.
Another pro is that your personal loan will typically have a lower interest rate. While this isn’t reported to credit agencies, having a lower interest rate and one payment should help you pay the debt off faster. That means that your debt will decrease more than it would if you were still paying on credit cards with higher interest rates. As your debt will be paid off sooner, once again, your utilization ratio will improve faster.
Debt consolidation can be a great way to pay off debt and pay less interest. Just keep in mind it needs to be done wisely. The goal here is to pay off debt and not to just move it around. By understanding your options and the consequences of those options before you decide to consolidate your debt, you can be sure to have the best possible effect on your finances and credit score.
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