How Does Debt Consolidation Affect Your Credit?
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When we think about creating a plan to attack our debt, we often wonder how it will impact our credit. This is probably one of the most important factors that come to mind when we try to figure out the best debt reduction strategy. When you’ve worked your entire life to maintain a relatively good credit score, the last thing you want to do is damage it.
However, there are definitely some cases where a credit sacrifice is needed. These cases are the most extreme and you might not have much of a choice. For many of us, there are still a handful of options to think through.
Debt Snowball/Debt Avalanche
How It Works: Both are terms we hear a lot about in the personal finance community. Simply put, the debt snowball method works by paying your lowest balance credit card first and work your way up. The debt avalanche method works by paying off your highest interest rate credit cards first. I firmly believe both are great options to consider. Yes, you may save more over the life of the repayment with one option but there is also something to be said about the emotional impact of the other.
Credit Score Affect: None of these two options will impact your credit score. One thing to keep in mind is you don’t want to close any of your accounts while you pay off the debt. Keep them open and try not to increase your balance. Since the #2 determining factor is the credit utilization, you should be seeing your score improve over time.
0% APR Balance Transfer
How It Works: If you’re able to get a 0% credit card offer to transfer your balances, this might be a viable option. Most creditors will charge around 3% fee capped at $75 max. This will usually last anywhere from 12-24 months. Transferring your balance will allow you to quickly pay off your debts without any interest. Make sure you read the fine print to determine if the APR after the promotional rate is acceptable.
Credit Score Affect: If you transfer your balance, chances are that you’ll actually see an improvement on your credit score. For example, if you maxed out your credit card with $10,000 and transfer your balance to another card with a $15,000 credit limit, you’re now utilizing 40% ($10,000/$25,000) of your credit versus 100%. One thing to keep in mind is to make sure you do your research on which credit card is right for you. You don’t want to keep applying for multiple credit cards only to be rejected. Each inquiry will have a negative impact on your credit score.
Debt Consolidation Through Personal Loans
How It Works: In years past, personal loans could only be received through banks with a HELOC. Times have changed. Personal loans can be used to consolidate your high interest rate credit cards. If you have multiple credit card or medical bills you want to pay off, a personal loan can be a viable option. These debt consolidation loans will give you one fixed monthly payment and a fixed interest rate to pay off your loan within five years.
Credit Score Affect: The good news is that some lenders will do a soft inquiry when you apply for a personal loan. If you’re thinking about consolidating your debts through a personal loan, consider lenders like Avant or LendingClub that pulls soft inquires. Initially, opening up an unsecured personal loan might impact your credit score negatively since you’re carrying more debt, but it really depends on your current profile as it stands. If you use the funds to completely eliminate your debts, your credit profile will paint a completely different picture. As you continue to pay on time and reduce your payments, a higher credit score is likely to follow.
No matter which method you choose, the ultimate goal should be to focus on debt payoff. Not only will this allow you to be financially free, but it will help secure lower rates on future mortgage or car loans.
Credit Counseling / Debt Management Program (DMP)
How It Works: Credit counseling companies may recommend a debt management program to tackle your debts. They have special relationships with creditors to put you on a fixed monthly payment plan to get out of debt within five years. Your interest rates will be lowered and your accounts will be closed. Your monthly payments will be managed by the credit counseling agency and they will disperse the funds to your creditors accordingly. Some credit counseling agencies might charge you a small monthly fee to manage your account. This is similar to the method I took to pay off my debt. I will also add that it took time to find the best organization to meet my needs. As with the other options, do your due diligence to make sure there are no red flags with the credit counseling agency.
Credit Score Affect: Once you enroll into a debt management program, there will be a notation on your credit score stating that you’re in a program. It’s a huge sigh of relief knowing that you have one fixed monthly payment, but all your accounts will be closed. This in itself will impact your credit score. Fifteen percent of your credit is determined by the length of your credit history and 10 percent is decided on the mix. So by closing these accounts, you’re damaging each area. However, in the long term, this program may actually help improve your credit score once your overall debt-to-income ratio has decreased.
What methods did you take to pay off debt? Did you choose to use credit after becoming debt free?
John is the founder of Frugal Rules, a dad, husband and veteran of the financial services industry whose writing has been featured in Forbes, CNBC, Yahoo Finance and more.
Passionate about helping people learn from his mistakes, John shares financial tools and tips to help you enjoy the freedom that comes from living frugally. One of his favorite tools is Personal Capital , which he used to plan for retirement and keep track of his finances in less than 15 minutes each month.
Another one of John's passions is helping people save $80 per month by axing their expensive cable subscriptions and replacing them with more affordable ones, like Hulu with Live TV.
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