In situations where people have several credit cards or loans with high interest rates that they find difficult to manage, debt consolidation appears as a viable solution. Debt consolidation means that a new loan is obtained so that all the other debts could be paid and a single monthly repayment is made. Although debt consolidation can help one clear the bills that they owe, many individuals ask whether this process will be bad for their credit rating. The following article provides a detailed overview of how debt consolidation impacts your credit.
How Debt Consolidation Affects Credit Scores
Closing Accounts As a result of debt consolidation, when you make payments to credit cards or other loans, you often get rid of those accounts. This may hamper your credit utilization ratio where the amount of credit that you’re using is to the total amount of credit available to you. Closed accounts are not any longer part of your credit file available credit; therefore the credit utilization ratio rises. Increased frequency of utilization leads to decreased credit scores. But credit scoring models do consider accounts that have been closed for a certain period more or less. In other words, the negative effect of closing accounts on FICO score is temporary and fades after a few years.
Opening a New Account Getting a debt consolidation loan entails applying for a new credit account. In most cases, the more accounts you have and have been managing for an extended period, the better it is for your credit. However, opening new account brings down the overall average age of your accounts and this reduce your score slightly. Your type of accounts and average time that the credit reporting agency has been tracking your credit information also affects your credit scoring, and new loan brings the age factor down. However, when compared to credit utilization, the account age issue is insignificant to most individuals with debt to consolidate.
Payment History They want to see responsible credit management and this is evident in payment of installments every month in the loan period. When you have several debts and repay them with a single loan, timely payments to the new creditor prove responsible financial management. As long as it enables you to maintain compliance in your payments then consolidating can in the long run assist in enhancing your payment history record and this is among the most influential factors in credit scoring models.
Considering the Strength and Weaknesses of Debt Consolidation
Lower Interest Rates The most common motivation for consolidating debt is to lower high interest rates on credit cards. This makes it possible to move the balances to a debt consolidation loan with a lower promotional interest rate for some time thus cutting down the total interest amount considerably. Making payments before the due date means that credit score will also be paid off faster. However, ensure that you compare different lenders who offer the lowest rate loans to benefit from consolidation of debts in terms of interest.
Single Payment Debt consolidation means that instead of making several payments in a month towards your credit cards or loans, you make a single payment towards a single debt consolidating entity. In other words, simpler and more easily managed payment schedules tend to enhance payment predictability. The most critical aspect for the credit scores is the ability to make regular payments, which is incorporated in the scoring models at over 35%.
Credit Inquiries Comparing loan offers from different lenders results in hard inquiries on your credit reports. Separately, each inquiry can cause credit scores to drop, at most, for a year. To reduce the effect of inquiries on credit scoring, models combine several loans inquiries within a given week or a month and consider it as one inquiry. Comparing rates from several lenders can be useful to determine the best loan offer if you apply for such loans within two weeks to reduce the number of inquiries that affect credit scores.
Fees Debt consolidation loans may attract some expenses, such as origination fees, which are charged by the lender. It limits the amount of money that is saved through debt consolidation by charging the borrower upfront fees that increase the cost of the loan. Do not incur high fees by carefully comparing the terms of different consolidation loans from several lenders.
Maintaining Financial Discipline Debt consolidation makes monthly payments and your repayment term easier and does not solve issues of overspending with the loans. If one is to consolidate debts and not repay the cards in full and accrue balances again, there is the need to exercise personal restraint in future to facilitate change that will eliminate the old habits of spending recklessly with credit cards. Responsible money management practices that sustain together with debt consolidation result in better credit ratings in the long run.
Considering the Advantages and Disadvantages of Borrowing Money
In conclusion, it can be said that debt consolidation can either reduce or affect credit ratings depending on credit performance and the manner in which loans are paid. One of the most important factors affecting your credit score is your payment history, which becomes easier to manage when using a consolidation loan to lessen the pressures on your monthly cash flow. However, if the fees charged for the loan are high or the lower interest rate is only available for a short introductory period, the benefits of consolidation would not outstrip the costs in terms of the impact on credit scores.
The credit profile and the situation of each individual is unique. Instead of expecting your score to be low, review the most recent credit reports that are provided by the three major consumer credit reporting agencies namely Equifax, Experian and Trans Union. Then use the free simulation tools from a myFICO to determine how the estimated consolidation of the debts with the different loan terms affect your FICO Scores. Understanding how your credit will be impacted ensures that you have all the information necessary before applying for a debt consolidation loan.
