How consolidating credit card debt affects your credit score
When used correctly and paid on time, credit cards can be useful to have. Of course, though it is always best to make payments on time, this is not always possible for everyone, and that is when some issues may start to arise. If you find that your credit card accounts are mounting up, and you’re suddenly being charged more than you can afford, debt consolidation may be an option that could help you out. But will debt consolidation affect your credit score?
What’s debt consolidation?
Debt consolidation is where you take multiple accounts and combine them together so that you only have a single payment to make. The primary purpose is to lower your interest rates. It also brings down monthly payments and reduces the number of companies you owe money to. There are several ways to consolidate credit card debt, but here are two popular options:
A balance transfer means using another credit card (existing or new) to pay off the balances on your other credit cards. You move the balances from your high-interest accounts to a single, lower-interest account.
This is where you borrow money in the form of a single loan to pay off your credit card debts. This means you only have to repay the single loan instead of the multiple credit card balances.
Let’s now look at the pros and cons of debt consolidation…
Consolidating your debts means you only have one payment to make now. This means you have, in theory, less to worry about, and less to keep track on.
Unlike many credit loans, which have revolving payments (meaning there is not a set number of payments) if you consolidate your loans correctly, then you should have a fixed loan that doesn’t fluctuate and where you have a fixed time to pay it off.
Continue to use credit cards
One of the biggest problems people have consolidating their loans is that they continue to use their credit cards. Not only will you have the payment to make on your consolidated loan, but you also have the same issue with your credit cards on top of that. If you’re unable to control your spending, closing your credit card accounts may be the best option. Though be aware that by closing them, it may damage your credit score, too.
If you choose to do a balance transfer, be aware that the temptingly low-interest rate which got you interested in the first place, will probably vary, usually after a year. This introductory rate which may have been very low when you first got it, will suddenly go up, and often by quite a lot.
Some consolidation loans force you to secure the debt against your house. So, if you fall behind on your payments, or can’t afford to repay them, you will be at risk of losing your home.
What’s a credit utilization ratio?
Depending on your situation, debt consolidation can benefit, or preserve, your credit score. In theory, consolidating your debts will help your interest rates, without damaging your credit score. By consolidating your debts, this will help reduce your credit utilization ratio. Your credit utilization ratio is a critical factor in calculating your credit score.
A credit utilization ratio is how much you owe relative to your credit limit. For example, you may have a credit limit of $5000 and owe $2000. However, if you then pay the monthly payment late, the lender can then lower your credit limit. As you use more and more of your credit limit, your revolving utilization ratio increases, and this almost always reduces your credit scores.
Overall, debt consolidation can be a great tool. It can help you to maintain or lower your credit score, and it can be useful in getting you out of difficult credit card situations — but use it alongside other methods such as tighter budgeting and behavior/spending changes.