Debt consolidation is both good and bad for your credit score. Since consolidating debts will help you manage your payments, it will be easier for you to keep up each month. At least, this is true if you have chosen the right debt consolidation plan. Since it is easier to keep up with the monthly obligations, it is more likely that you can improve your payment behavior. This is one of the best ways to improve your credit history.
With the average FICO score at 703, you can assume that people have learned their lesson when it comes to managing their debts. Since Americans have accumulated a huge amount of debt once more, there is a need to use a debt relief program to help pay off their credit obligations. For a lot of people, debt consolidation seems like the best way to get out of debt. It is also the option that has the least effect on your credit score – but only if you know what you are doing.
How can debt consolidation ruin your credit score
Although it is considered to be the option with the least effect, that does not mean it will not alter your score in some way. There are different ways that your credit report will be influenced by debt consolidation, which in effect, can change your current credit rating negatively.
Through hard inquiries
If you choose a debt consolidation loan, the lender that you applied to will pull a hard inquiry on your credit report. This will allow them to look at your credit report and see your payment behavior, credit utilization rate, the number of credit accounts you have opened, etc. The information is meant to reveal your creditworthiness through your credit score. It will help lenders decide if you are most likely to pay off your debts without a problem. If you are deemed to be a high-risk, they will impose a bigger interest rate on the loan.
You have to be careful with hard inquiries because having a lot will make your score go down. One inquiry is said to lower your score by 5 points. If you have a lot of inquiries within a short period, that can be interpreted as a desperate attempt to borrow a lot of money through various lenders. This will not look good on your score and it will also deem you as a high-risk borrower. Choose only the loans or credit accounts that you have a high chance of getting approval and has the best terms.
Through average credit age
Your credit report also reflects the average credit age of all your accounts. This means if you have 3 credit accounts that were open for 3, 5, and 7 years already, your average credit age would be 5 years. If you open a new account now, that would add a new account with 0 years. That means your average credit age will now be approximately 3.75 years. The lower the average credit age, the more you are deemed a high-risk borrower. A higher credit age means you have maintained your credit accounts over a long period without feeling the need to close any of them. It shows that you know how to maintain your credit accounts well.
Through credit utilization
This is the ratio between your credit balance and limit. The more balance you have, the more negative impact on your credit score. So how does this relate to debt consolidation?
Sometimes, people make the mistake of feeling like debt consolidation already paid off all their balance. After all, the credit accounts that used to have debt now reflects a 0 balance. This is why some people are tempted to use credit once more. According to one survey, 1 out of 5 respondents admitted that they use their credit cards to pay for basic living expenses. This means these people will not really stop using their cards.
You have to remember that you just transferred your balance when you consolidated debts. You still owe the same amount of money. By using your cards, you will be adding to what you owe. This will reflect badly on your credit utilization rate, and in effect, your credit score.
Another way that your credit utilization can be affected is when you close your credit cards. After debt consolidation, the original credit accounts will be left with zero balance. Some people opt to close the account to avoid the temptation of using it again. While the intention is understandable, it might not be good for your credit score. Closing credit cards will lower your credit limit. Since your balance is still the same, it will affect your credit utilization rate negatively.
Through late or missed payments
Remember how debt consolidation can pull you into a false sense of debt freedom? Consolidating debts makes your payments easier. If done correctly, you should be able to make payments despite threats of a financial crisis. However, there is a danger in seeing your old credit accounts with a zero balance. It will make you feel complacent. This can be a dangerous feeling especially if it makes you forget the urgency of making payments. Once you feel too relaxed, you might feel like paying off your debts is a priority. When that happens, you will start missing out on payments. Your credit score is significantly influenced by your ability to pay your dues on time. Late payments can quickly pull your score down so you need to make sure you remember to meet your due dates.
Use debt consolidation to improve your credit score
While debt consolidation can have a negative effect on your credit standing, this should not deter you from using it – especially when you know it is the perfect debt solution. The thing about credit scores is that it is constantly changing. Even if you start out with a low score, it can go up as long as you practice the right credit behavior.
These are some of the things that you can do while you are in the midst of a debt consolidation program.
Pay your dues in time
Start by paying your dues in time – and making sure it meets the minimum amount. You need to improve your time management and organization skills so you can stay on top of your credit obligations. As long as you keep on paying on time, this will help pull up your credit score.
Stop borrowing money
Another thing that you should do is to stop borrowing money while you are still paying off the debt you consolidated. Do not think you are out of debt just because of the zero balances that you see in your credit accounts. You need to keep your debts low to improve your credit utilization rate. The ideal level is 30%. That means if your overall credit limit is $10,000, your debts should not go higher than $3,000. Do not borrow until you have a balance that is lower than this amount.
Do not close old credit accounts
No matter how tempting your cards may be, do not close them. If you really have no use for them, it is okay to close them – but not yet. Wait until your credit score has risen after paying off a significant portion of your balance. Only then can you close the credit accounts that you do not use. Make sure to schedule each account. Do not close them all at once.