Like so many questions related to finances, whether debt consolidation is the right choice for you depends upon your specific situation. Debt consolidation can be achieved by combining multiple credit card balances into a single payment, either through a lower interest personal loan or a balance-transfer credit card that offers a 0% APR (annual percentage rate) for a limited introductory period. We’ll look at both means in this guide.
First some background: Several factors can affect your credit score, and it’s important to understand how credit score algorithms consider them. For example, FICO® Score uses the following breakdown for credit scores:
• Payment history (35%): This includes delinquent payments and information found in public records.
• Amount currently owed (30%): This includes money you owe on your accounts as well as how much of your available credit on revolving accounts is currently in use.
• Credit history length (15%): This includes when you opened your accounts and how long it’s been since you used each account.
• Credit types used (10%): What is your mix? For example, how much is revolving credit, such as credit cards? How much is installment debt, such as car loans and personal loans?
• New credit (10%): How much new credit are you pursuing?
The following information can help you make the right debt consolidation decision.
Table of Contents
Key Points
• Debt consolidation provides an opportunity to analyze your financial situation and implement a new budget and savings plan.
• A consolidation loan can help your credit score if you make payments on time, keep your credit utilization low, and maintain a mix of credit types.
• A consolidation loan can hurt your credit score if you make payments late, fall back into debt after paying off the loan, or close your credit accounts.
• Before getting a loan, shop around with multiple lenders to find the best interest rate and loan terms you qualify for.
• Combining multiple credit card debts into one loan can lower the interest you pay and reduce the chance that you will accidentally miss a payment.
Benefits of Debt Consolidation
The main advantage of debt consolidation is saving money on interest. Credit cards tend to have high rates: 20% to 25%. When you make only the minimum payments on them, you can pay a significant amount of money each month in interest, without seeing your balances drop much at all.
The average interest rate on a personal loan for debt consolidation is 12%. Not only will you save money, but you’ll pay off your debt much faster, typically between 2 and 7 years. If you use a balance-transfer credit card instead of a loan, you’ll need to pay off your balance within the introductory period, before the 0% APR reverts to market rates.
Another benefit is streamlining your bill paying. If you’re using multiple credit cards, it can be easy to accidentally miss a payment. Depending on the severity of the mistake, this can have a negative impact on your credit score, which can make it more challenging to qualify for loans or for low interest rates and other favorable terms. Combining multiple credit cards into one loan or credit card can also help prevent you from accidentally missing a payment.
How you handle your debt consolidation and how you manage your finances after the consolidation play significant roles in whether this strategy will ultimately help you.
Steps to Take Before the Debt Consolidation Loan
People accumulate debt for different reasons. For some, they didn’t have emergency funds available to cover unexpected medical bills or home repairs. For others, being underemployed for a period may have caused them to start carrying a credit card balance. Still others may never have learned how to budget effectively.
No matter why your credit card debt has built up, it may be helpful to think of a debt consolidation strategy as more than just combining your bills. As part of your plan, analyze why your debt accumulated, and be honest about which expenses were under your control and which were true emergencies. If you end up using a lower-cost loan or 0% APR credit card to consolidate your bills, consider using any money you save to build an emergency fund to help prevent the accumulation of credit card balances in the future.
Consolidating your debts, if done in conjunction with a carefully crafted budget and savings plan, can be the first step in your brand-new financial strategy.
When Debt Consolidation Can Help Your Credit Score
Based on the factors FICO considers, here are ways a consolidation loan can help your credit score.
Payment History (35%)
Making payments on time is the biggest factor in FICO credit scores, so a debt consolidation loan can positively impact your credit by reducing the number of bills you have to manage.
Amount Currently Owed (30%)
Although you may not instantly reduce the amount you owe by consolidating all your credit card balances into a personal loan, your credit score can still benefit from it. That’s because the credit score algorithm looks at the credit limits on your cards as well as your outstanding balances, then calculates your credit card utilization. Using a personal loan to pay off your cards is one way to lower your utilization.
Here is more information about credit card utilization, including how to calculate and manage yours.
Credit Types Used (10%)
There are several different types of credit, including credit cards, retail accounts, installment loans, finance company accounts, and mortgage loans. According to FICO, responsibly using a diverse mix of these, such as credit cards and installment loans, may help your credit score.
However, it’s certainly not necessary to have every type of credit, and it’s not a good idea to open credit accounts you don’t intend to use.
When Debt Consolidation Can Hurt Your Credit Score
Now here are ways that consolidating debt through a loan or balance-transfer card may hurt your credit score.
Payment History (35%)
As with most loans, making late payments can hurt your credit score. Loans in a delinquent status will have a negative impact on your credit to various degrees, depending on the lenders’ policies.
Amount Currently Owed (30%)
What if you pay off all your credit cards with a personal loan but then begin using them again to the extent that you can’t pay them off monthly? Any gain that you saw in your credit score will disappear as your credit utilization numbers rise again.
Another way that credit consolidation can harm your score is if you combine all your credit card balances on just one credit card and close the other accounts, resulting in a high utilization rate. However, if you can keep the usage rate relatively low, that’s less likely to negatively affect your score.
Credit History Length (15%)
Closing credit card accounts after paying them off can have another negative effect: You may reduce the overall age of your accounts, which can hurt your credit score.
Credit Types Used (10%)
If you combine all your credit card balances into just one credit card, instead of taking out a personal loan, that won’t help with diversifying your credit types.
New Credit (10%)
If you apply for a personal loan or a balance-transfer credit card but are rejected, this can cause your credit score to decrease. Applying for multiple loans or credit cards over an extended period of time, while looking for a lender who will accept your application, can also hurt your score. However, multiple requests for your credit report information (known as “inquiries”) in a brief period of time typically won’t decrease your score.
Concerned about building or rebuilding credit? Check out a few tips SoFi put together on how to strategically build your credit score.
Recommended: How to Get a Debt Consolidation Loan with Bad Credit
Investigating a Personal Loan for Debt Consolidation
If you are considering applying for a personal loan, it’s important to get the lowest rate you can. But you shouldn’t focus on interest rates exclusively. When choosing a lender, ask about the fees associated with the loan. Some lenders have hidden fees, but others — like SoFi — do not. A lender’s APR includes both the interest rate and any required fees. Compare the APRs of multiple loan offers to understand the actual cost of financing.
You should also calculate the shortest loan term that your budget can comfortably accommodate. The sooner you pay off the debt, the more money you’ll save because you’ll pay less interest.
You can find more information about saving money through debt consolidation, and you can also calculate payments using our personal loan calculator.
Recommended: Will a Personal Loan Build Credit?
The Takeaway
If you’re ready to say goodbye to juggling multiple payments each month, debt consolidation may be a good option. You can consolidate credit card debt through different means — typically either a lower-interest personal loan or a 0% APR balance-transfer credit card. With the latter, you’ll need to pay off your debt before the introductory 0% APR expires (usually 6 to 21 months). With a personal loan, you can repay the principal over up to 7 years.
Credit cards have an average APR of 20%–25%, and your balance can sit for years with almost no principal reduction. Personal loan interest rates average 12%, with a guaranteed payoff date in 2 to 7 years. If you’re carrying a balance of $5,000 or more on a high-interest credit card, consider a SoFi Personal Loan instead. See your rate in minutes.
FAQ
What are the short-term benefits of debt consolidation loans?
A debt consolidation loan can help you manage your debt because you have only one monthly payment to keep up with. It can also save you money, as interest rates for loans are usually lower than those for credit cards.
What are the potential risks of debt consolidation for credit scores?
When you have only one monthly payment, making that payment late has a greater negative impact on your credit score than being late on one of several payments. Additionally, if you consolidate your debts into a single credit card instead of a loan, this can increase your credit utilization rate and lower your credit diversification, both of which can lower your credit score. Closing credit card accounts after paying them off is another risk, as this may reduce the overall age of your accounts.
How can responsible debt management build credit scores after consolidation?
Consolidating your debts gives you the opportunity to evaluate your financial situation and implement a better strategy for how you use credit. If you can limit your credit purchases to those that are essential, you are more likely to be able to pay down your debts in a timely fashion and avoid unnecessary interest.
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