How Does Debt Consolidation Affect Your Credit?

Debt consolidation is a financial strategy that many individuals consider when overwhelmed by multiple debts. Taking out a single loan to pay off several others may result in lower interest rates and simplified repayment terms.

If you’re carrying multiple debts, the opportunity to free yourself from making payments to several lenders each month can feel like hitting the refresh button on your finances. For many, debt consolidation loans serve as a pathway to simplifying their lives and finances by combining multiple debts and payments into one.

While this approach can offer some relief from having to pay multiple creditors, consolidating your debt can prompt questions about its impact on credit scores. Debt consolidation loans can have various effects on your credit score, so make sure you understand how these loans work before you apply.

Does debt consolidation mess with your credit?

The short answer is — it depends. Debt consolidation can influence your credit score positively or negatively, depending on various factors such as your financial habits and the type of consolidation you choose.

As long as you're consistent and timely with your loan payments, the overall impact of debt consolidation on your credit could be positive. But let's look deeper into the ways consolidating debt might affect your credit.

Why does debt consolidation affect your credit?

Debt consolidation can affect your credit for several reasons. First, consolidating multiple debts into one often involves opening a new credit account, such as a personal loan or balance transfer credit card. This new account can initially lower your credit score due to the hard inquiry made by the creditor during the application process.

Closing old accounts as part of the consolidation process can also impact your credit utilization ratio, which is the amount of credit you're using compared to your total available credit. Closing accounts can reduce your available credit, potentially increasing your utilization ratio and lowering your credit score.

However, by making timely payments and reducing your overall debt, managing your new consolidation loan responsibly can have a positive impact on your credit score over time.

Pros of a debt consolidation loan

There are several advantages to consolidating your debts.

• Combining several monthly debt payments into one makes managing your finances easier.

• A debt consolidation loan with a lower interest rate than you’re paying on your current debts could save you money on interest. Depending on the length of your new loan, you might even pay off your debt faster.

• Since credit utilization accounts for 30% of your credit score,¹ a debt consolidation loan can have a large impact on your credit. If you manage your loan responsibly, you’ll notice a reduction of your overall debt and a lower credit utilization ratio over time.

• Making on-time monthly payments for the life of your loan helps build a consistent payment history, which will help improve your credit score over time.¹

• Since your credit mix accounts for approximately 10% of your score, opening a debt consolidation loan may strengthen your credit score by adding a different type of account to your credit report.

Cons of a debt consolidation loan

Despite possible benefits, debt consolidation also comes with potential drawbacks.

• Applying for any loan, including a debt consolidation loan, triggers a hard inquiry on your credit report, which might lower your credit score temporarily.

• As payment history is the most important factor in calculating your credit score (accounting for 35% of your FICO score²), even one missed payment could negatively impact your credit score.

• When you consolidate existing debts, your total finance charges over the life of the new loan may be higher than for your current debt because the new interest rate might be higher and/or the (new) loan term may be longer than the old.

• After combining your existing credit card balances into one debt consolidation loan, you could be tempted to use the newly freed-up space on those cards, which would lead to even more debt.

How long does a debt consolidation loan stay on your credit?

Even though you won't see the term "debt consolidation" on your credit report, its impact can linger for several years. Just how long depends on how you manage repaying the loan. If you have setbacks, like being late with payments, that negative information could show up on your credit report for seven years. But if you've paid on time and closed the account in good standing, that positive record lasts for 10 years.³

What are other options for debt consolidation?

Debt consolidation loans aren’t the only option for paying off multiple debts. Below are a few alternatives to consider. Keep in mind that each comes with its own set of benefits and drawbacks. The right choice for you depends on your individual financial situation.

• Balance Transfer Credit Card — You could look into moving your high-interest credit card balances onto a single card that offers a lower annual percentage rate (APR). But keep in mind that many cards offer low introductory rates that only last for a specific period. After that, a higher rate kicks in.

• Home Equity Loan or Line of Credit — You could use the equity in your home to secure a loan or line of credit. Typically, interest rates for these types of loans can either be variable or fixed. However, understand that your home acts as collateral, which means there's a risk of losing it if you don’t make the required payments.

• 401(k) Loan — Some employer-sponsored retirement plans allow you to borrow money from your account. This could be a convenient debt consolidation option, but know there are risks involved, like penalties and taxes if you're unable to repay the loan on time.

• Friend or Family Loan — If you decide to borrow from friends and family, be sure to set clear repayment terms so the financial relationship doesn’t harm your personal relationship. If there's uncertainty or potential for complications, you might be wise to explore other borrowing options.

Make debt consolidation work in your favor

Ultimately, the key to making debt consolidation work in your favor is to approach it responsibly. Be sure to carefully evaluate your options, choose the right strategy for your financial situation, and commit to disciplined repayment. Consistent on-time repayment helps establish good financial habits and might improve your credit score over time so you — and your finances — can keep making progress. OneMain Financial can help simplify your finances with a debt consolidation loan.