Debt Consolidation and Its Impact on Credit Score

If you are like most Americans, you would perhaps not be a stranger to credit card debt. If you are having trouble in keeping track of multiple debts and making the payments on time, then you have several options for managing the situation. One popular way is consolidating your debt; however, simple as the process may be to understand and implement, it should be appreciated that it can have an impact on your credit score.

Consolidation Explained

In simple terms, consolidation of debt entails taking out a new loan of a value equivalent to your existing multiple debts so that you can pay them back. After you do so, you are left with just a single debt requiring a single monthly payment to pay it off. The reason why it is so popular is because you can invariably switch to a loan that carries a significantly lower rate of interest compared to the really steep rates charged by the typical credit card issuer. Getting a consolidation loan is also a perfect opportunity to structure your debt in such a way that the monthly payment to be made is now within your budget. This is done by stretching the loan longer but you should be careful not stretch the tenor beyond what you really require as you will end up paying a lot more interest over the loan period.

How Can You Consolidate Your Debt

Consolidation can be achieved using a number of routes. Firstly, you could consider sweeping all your credit card outstanding to a card that carries a lower rate of interest so that you not only achieve the mission of having only one debt but also lower your interest expense.

Another route is by taking a loan that is secured by your home; such loans carry a low rate of interest but you really need to be careful in paying back the loan as per schedule, else you could end up losing your home, so usually this is not recommended unless you are absolutely certain that there will be no hiccups in the loan repayment. The most-favored route is the personal loan taken from a private financier, a bank, or a credit union.

Impact of Debt Consolidation on Your Credit

The extent of the impact of debt consolidation on your credit depends on the option being chosen. Remember that when you apply for a loan or even a new credit card, your score will take a hit due to the inquiry. However, since the credit score also depends on the credit utilization that is basically the ratio of debt taken by the allowable limit, by taking on a new card, you can actually reduce your utilization and improve your credit score. However, it is also important to keep in mind that if any card has a very high outstanding, it will depress the credit score, so your score could actually take a hit even though you have paid off all other cards fully.

On the other hand, if you take a consolidation loan to pay off your credit card debt, your utilization ratio will dip and as a result, the credit score will be boosted. However, for this to take place, you should ensure that you keep your credit cards open even after the balances have been paid off.

Conclusion

Consolidation of debt can be a very useful strategy to restructure your debt so that you can pay it off without stressing yourself. Selection of the route is important as there could be a negative impact on your credit score. The least harmful way is to take on a personal loan, pay off your credit cards, and hope that with time, your credit score will improve. It is also very important not to start using your credit cards recklessly now that they have been paid off.