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Dear Credible Money Coach,
Is it true that when you take out a debt consolidation loan, it hurts your credit? —Twila
Hello Twila and thank you for your question. Debt consolidation affects your credit differently depending on how you structure it and manage loan repayments. This can be a smart way to manage multiple high interest debts without hurting your finances.
Why do people consolidate their debts?
When you consolidate debt, you open a new credit account, such as a personal loan, credit card, or home equity loan, to repay several existing debts. This leaves you with one payment instead of multiple accounts to manage.
If you have good credit, you may be able to get an interest rate that’s lower than the combined effective rate you’ve paid on multiple debts. This saves money in the long run.
Ways to Consolidate Debt
There are several options for consolidating debt, including:
Each of these options has advantages and disadvantages. For example, personal loan interest rates are generally lower than credit card rates. But if you continue to incur credit card charges, you could go into more debt.
Doing a 0% balance transfer could save you interest for 12 months or more. But if you don’t repay the entire balance before the end of the promotional period, the interest rate could increase significantly.
If you sign up for a debt management plan with a credit counselor, they can negotiate with your creditors to pay less than you owe, lower your interest rate, or extend your repayment period. But if you can’t repay a debt management plan as agreed, your credit may suffer.
Risks of a debt consolidation loan
A debt consolidation loan can lower your credit scores in the short term. This is because new credit applications cause your scores to drop. And if you use the loan to pay off a credit card and then close it, you reduce your total available credit, which leads to lower credit scores. (It’s best to keep a paid credit card open so you have more credit available in your name.)
However, if you make your new loan payments on time each month, your credit should recover fairly quickly from the slight hit it took when you opened the loan.
Should you get a debt consolidation loan?
A debt consolidation loan is not for everyone. I advise you to think twice before emptying a retirement account to pay off debt or putting your home at risk with a home equity loan or line of credit.
And if bad spending habits are causing your debt, working with a qualified credit counselor to improve your financial habits may be more helpful than lowering your interest rate with a debt consolidation loan.
If you decide a personal loan is right for you, Credible can help. compare personal loan rates from multiple lenders without hurting your credit.
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About the Author: Laura Adams is a personal finance and small business expert, award-winning author and host of silver girl, a weekly audio podcast and top notch blog. She is frequently quoted in the national media and millions of readers and listeners benefit from her practical financial advice. Laura’s mission is to empower consumers to live richer lives through her work as a speaker, spokesperson and advocate. She earned an MBA from the University of Florida and lives in Vero Beach, Florida. Follow her on LauraDAdams.com, instagram, Facebook, Twitterand LinkedIn.