Do Debt Consolidation Loans Affect Your Credit Score?
How Does Debt Consolidation Loans Impact Your Credit Rating?
If you are in a position to have more than one debt, including credit card balances, medical bills, or personal loans, then debt consolidation is a way of easing payment if you consolidate all the debts into a single consolidated loan. This can make the management of debt easier every month through a single installment which is absolutely convenient. Nevertheless, one needs to understand how consolidation of a loan affects his or her credit score when applying for one. Below, I give a brief of how debt consolidation processes and how it affects credit rating.
How Do Debt Consolidation Loans Function?
One obtains a new personal loan under debt consolidation meant to help pay off prior debt. Under one rate of interest, this clever consolidation loan gathers all of your debt into one amount. In a perfect world, this new loan should have a smaller interest rate than past loans, therefore lowering the monthly payment amount. Moreover, you will only have one monthly payment to pay one lender, which will assist to ease your financial load.
One method one might handle credit card debt is debt consolidation. But these loans could also include with unsecured debt like credit card cash advances, personal loans, payday loans, doctor's bills, and more. Your credit score guides both your qualifying for a consolidation loan and the interest rate of the loan.
Short-term impact on your credit
Contrary to this, in the short run, a debt consolidation loan can lead to a reduction in your credit score. Here are two main reasons why.
- Closing Credit Card Accounts: After making credit card balances through a consolidation loan, you should close such credit card accounts to some extent to avoid incurring more bills. Nevertheless, closing accounts is not advisable since they affect the credit utilization ratio, that is the amount of credit limit being utilized. In general, it is best to keep the credit utilization below 30 percent. But, if you close your accounts then available credit will decrease and utilization ratio will increase which will not do any good to your credit score.
- New Credit Inquiry: Any consolidation loan application you take will be subjected to a credit check by all the lenders. This results in a new hard credit check on your credit report and your credit score is reduced by a few points. But all these are normally temporary and you can regain your score in a few months. Several requests in a short period can cause more harm, so stagger applications and do not apply for new loans for some time after receiving a consolidation loan.
How Long Do the Effects Last?
The impact that the application of a consolidation loan has on the credit score ranges only for a few months. If you maintain a proper payment on your new loan every month, you will begin to see your score improving. Most credit scoring models do not count inquiries older than 12 months. Thus, if you provide it for roughly half a year to a year, then your score should recover from the new inquiry completely.
If you have recently requested for early closure of some of the credit card accounts, it is likely to take time before this area stops impacting your credit utilization ratio. Also, remember you will also be removing one less account that is providing a positive payment history to your credit report. The fewer the total accounts that you have that are in good standing, the more each missed payment translates in terms of credit score.
Long-Term Credit Score Impacts
In the long run, therefore, being able to manage your debt consolidation loan responsibly has very positive impacts on your credit rating. Here are some of the key benefits for your credit as you pay down your consolidation loan.
- Improving Credit Mix: Credit scoring models prefer to have diverse active accounts with positive payment histories, such as both installment loans and credit cards or credit lines. Having an open installment loan on your credit report after paying off credit card balances using a consolidation loan helps to diversify your credit report.
- Increased Payment History: Timely payment of the consolidation loan for some months or years shows the ability of the borrower to handle the debt. This creates your referred track record to show how you have been making the payments over the extended period.
- Lower Credit Utilization: When you are repaying your consolidation loan, your outstanding balances are lower each month, and this is good for you. For this illustration, let your loan balance be 50% of your total credit line on all your accounts. And on a three-year loan term, that percentage is gradually reduced with every monthly payment along with your credit utilization ratio. This has a progressively beneficial effect on your score.
- Avoid Debt in Collections: Debt consolidation has a clear-cut strategy of how to deal with debts to ensure that no accounts get to a stage of going to collections which is very detrimental to your score. It proves to future lenders that you can take back charge of your finances and repay the loan.
Here is a breakdown of the pros and cons of your situation.
However, some potential drawbacks of consolidation are temporary reduction of credit score caused by inquiries at the beginning of the consolidation process or closure of credit card accounts that were paid off. However, always remember this trade-off and consider the effect that taking out a debt consolidation loan is going to have on your credit status before proceeding. It is important for one to closely watch the score during the loaning period.
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