Debt

Will Debt Consolidation Hurt My Credit?

Debt consolidation shouldn't hurt your credit if you don't get into more debt. Learn how to consolidate debts and build your credit score in the process.
A man sits at a desk with his cell phone in his hand while he works on getting a debt consolidation loan
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By Gina Freeman
Posted on: August 31st, 2021

Debt consolidation, if completed successfully, can improve your financial position by reducing the interest rate you’re paying on your debts, shrinking your monthly payment, and simplifying your debt management. But how will it affect your credit scores? Does getting a debt consolidation loan make you look irresponsible to creditors?

The relationship between debt consolidation and credit scoring is complicated. Here’s what you need to know.

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How Debt Consolidation Can Harm Your Credit Score

Debt consolidation can do minimal damage to your credit score because every application for a debt consolidation loan generates a credit inquiry. According to FICO, the inventor of the most popular credit scoring models,”For most people, one additional credit inquiry will take less than five points off their FICO Scores.”

Why credit inquiries lower your credit score

However, if you apply with multiple lenders for a debt consolidation loan, the effect can be much greater. Because, FICO says, “Statistically, people with six inquiries or more on their credit reports can be up to eight times more likely to declare bankruptcy than people with no inquiries on their reports.”

Damage from unsuccessful debt consolidation

Debt consolidation can indirectly harm your credit score if you pay off your credit cards with a debt consolidation loan and then run them back up. Increasing balances mean you are spending more than you earn. That’s why credit scoring models punish consumers who use too much of their available credit and carry balances.

Minimizing the damage

Some providers of personal loans for debt consolidation allow you to prequalify for a loan and see your rate without pulling a credit report. It’s important to prequalify whenever possible. You can also minimize inquiries by applying with lenders that lend to people in your credit scoring range. You can find them by completing an inquiry form like the one on this site.

If you believe that your spending habits are the problem, don’t consolidate your debt without first completing credit counseling and understanding debt management. If overspending is your issue, a debt management plan (DMP) from a non-profit credit counseling service might be a better option than a loan. DMPs can harm your credit score because you have to close every account included in them, but you won’t be adding to your debt.

Debt Consolidation Usually Helps Your Credit Score

While your credit score will probably take a small hit when you apply for a debt consolidation loan, paying off revolving accounts like credit card balances with an installment loan (like a personal loan or home equity loan) can improve your credit score a great deal, almost instantly. That’s because of another credit scoring factor called “credit utilization.”

What is credit utilization?

Credit utilization makes up 30% of your credit score. You calculate your utilization ratio by adding up all of your revolving account balances and dividing that by the total of all your lines of credit. So, if your credit lines total $10,000, and your balances total $8,000, your credit utilization is $8,000 / $10,000, or 80%. That’s a very high utilization rate.

Consumers with the best credit scores keep their utilization under 10%. Most personal finance experts recommend keeping your utilization under 30% for financial health.

By paying off your credit card balances with an installment loan like a personal loan for debt consolidation, you drop your credit utilization ratio to zero. That’s because installment loans don’t count in credit utilization calculations.

You don’t have to close your paid-off accounts as long as you have the discipline to pay them in full every month and not overspend. Note that consolidating your debt with a balance transfer credit card won’t drop your utilization to zero. You’ll still have a credit card balance. But it can cut utilization in half.

How else can debt consolidation help your credit score?

Debt consolidation may raise your credit score by improving your mix of credit. If your debt mostly consists of revolving accounts like credit cards, your profile is unbalanced. Credit mix comprises 10% of your credit score, and adding a personal loan or a home equity loan to your mix might up your credit score by a few points.

In addition, if consolidating makes repaying your balances more affordable, you may have fewer late payments. Pay your debt consolidation loan on time every month, and your good repayment history will help improve your score. Repayment history makes up 35% of your credit score — it’s the most important of all credit reporting factors.

Can Lenders Tell if You Consolidate Your Debt?

Debt consolidation with a loan is not reported to credit bureaus and it does not appear on your credit report as such. Any underwriter who pulls your credit report will see (hopefully) a bunch of credit cards with zero balances and an installment loan, mortgage, or balance transfer card with all of your debt wrapped in.

When you apply for financing, the underwriter will add up your monthly debt and housing payments, divide that by your monthly gross (before tax) income and calculate your debt-to-income ratio (DTI). If your credit score and DTI meet the lender’s guidelines, it’s likely to approve your application.

If you run up credit card balances while you still have your debt consolidation loan, your DTI is likely to be too high for many programs. In addition, your credit score will take a hit as your credit card balances increase.

If you consolidate debt with a DMP, the plan does not report to credit bureaus. However, individual credit card companies do report. If they are making concessions like reducing your interest rate, payment or balance, they are likely to report that. Lenders will see it when they pull your credit report.

The main issue when consolidating debt is not the temporary hit your credit score might take. It’s getting yourself financially healthy. If consolidating debt is right for you, your credit score will improve in the long run as you get your debt under control.

About the Author

Gina Freeman is a personal finance specialist with AmOne. Her career has covered business credit, bankruptcy, tax accounting, and mortgage financing, and she has been a finance writer or editor for over 15 years. Gina is extremely consumer-focused and enjoys breaking down complex topics to help readers make confident financial decisions.