The process of debt consolidation can make your life easier and can even help improve your credit score.
Consolidating debt involves combining multiple sources of debt into one loan or onto one balance transfer credit card. This enables you to focus your debt repayment efforts on a single payment with one monthly due date. If you make payments on that new loan or credit card on time, you can also give your credit score a boost.
- How to consolidate debt
- How debt consolidation helps your credit
- Can debt consolidation hurt your credit?
- Should you consolidate your debt?
- Alternatives to debt consolidation
How to consolidate debt
There are a handful of different ways you can consolidate debt:
- Balance transfer credit card: Many credit card companies offer introductory 0% annual percentage rates (APRs) on balance transfer cards when you consolidate your credit card debt this way. These introductory periods must last at least six months, and may last as long as 21 months or more.
Using a balance transfer card can simplify your payments, since you’re combining multiple high-interest debts. It can also help you save money on interest if you pay off the debt before the introductory period ends.
Keep in mind that after the introductory period ends, the card will return to its regular rate, which could be higher than what you were paying on your other cards. You also typically have to pay a balance transfer fee, which is often 3% of the amount you’re transferring. Before getting a balance transfer credit card, consider if it’s worth it once you factor in this fee. - Debt consolidation loan: You can take out a debt consolidation loan from a credit union, bank, or online lender. A debt consolidation loan combines different sources of debt into one new loan with a single monthly payment. This can potentially reduce your interest rate, since personal loans generally have much lower interest rates than credit cards. However, keep in mind that if you opt for a longer repayment term, you may end up paying more in interest in the long run.
- Home equity loan: A home equity loan is a second mortgage that allows you to borrow up to 80% of the equity in your home. Like a debt consolidation loan, it has a fixed interest rate and you repay it in monthly installments. However, it uses your home as collateral, making it a risky option.
How debt consolidation helps your credit
Debt consolidation can help you improve your credit score in a few ways, including:
- Can lower your credit utilization ratio: When you consolidate your credit card debt, you can reduce your credit utilization ratio — the total revolving debt you’re using divided by your total credit limit. This ratio should ideally be below 30%. Instead of having multiple maxed-out credit cards, you’ll have just one card with a higher limit, or one loan that diversifies your credit mix and could help boost your score.
- Can improve your payment history: If you make on-time payments every month, it can improve your credit score. Having a loan with a lower interest rate, or a card with a 0% interest introductory period, can make it easier to pay off your debt.
Can debt consolidation hurt your credit?
Debt consolidation can potentially harm your credit score due to the following:
- Hard credit check: When you apply for a debt consolidation loan, the lender will perform a hard credit check. This can drop your credit score by around 5 points and may affect your score for a few months to a year.
- New account: Opening a new credit card or taking out a new loan will add a new account to your credit report. This lowers the average age of your accounts, which makes up 15% of your FICO credit score.
Should you consolidate your debt?
Consolidating debt can be a good choice if you’re struggling with high-interest rates and multiple payments with different due dates. It can help streamline the debt repayment process.
However, consolidating debt doesn’t always make sense. For example, if your debt is already manageable and you’re able to make your payments on time, you may not need to consolidate and add an unnecessary hard inquiry to your credit report. And if you don’t have a good credit score, you may struggle to qualify for a personal loan with a low-interest rate or a 0% APR balance transfer card.
Alternatives to debt consolidation
If you don’t think debt consolidation is the right move for you, these are some other options available to you:
- Try a new debt repayment strategy. There are two popular debt repayment strategies that may help you make progress — the debt snowball and debt avalanche methods.
With the debt snowball method, you prioritize paying off the card with the smallest balance first, while making minimum payments on your other debts. You then move on to the next-smallest balance until all debts are repaid. This method can provide a sense of accomplishment and motivation as you see the debts disappear.
The debt avalanche method is similar to the snowball method, but instead of prioritizing the lowest balance, you start with the debt with the highest interest rate. This method can save you more money in the long run, but it may take longer to see progress. - Contact your credit card companies. If you explain your situation, your credit card issuer may be willing to work with you on a payment plan or change your monthly due dates.
- Pursue credit counseling. A credit counselor can help you create a budget and develop a plan to pay off your debts. They can also provide guidance on how to manage your finances and avoid getting into debt in the future. You can find nonprofit credit counseling agencies through the National Foundation for Credit Counseling.
- Create a debt management plan. Another service you can take advantage of with a credit counselor is a debt management plan. This is a voluntary agreement with your creditors designed to help you pay off your debts in a structured manner.
Working with a credit counselor, you agree on a plan to repay your debts and make one monthly payment to the credit counselor. The counselor will then distribute the money to your creditors until your debts are paid off. Your credit counselor may even be able to get fees waived or lowered.