Consolidating your debts can lower your monthly payments and make it easier to get back on solid financial ground. Many people also look into debt consolidation hoping that it will improve their credit scores.
The situation is a bit complicated, but consolidating debts can certainly improve your credit rating in the long term. There are some related factors, though, that can actually lower your credit score, at least temporarily. It will still almost always be wise to seek help with debt consolidation if your situation merits it, especially when you understand the issues.
Hard Inquiries Will Temporarily Lower Your Credit Score a Bit
The FICO credit scores that most lenders rely on are based on several factors. One that sometimes gets overlooked is whether and how many times a consumer’s credit report has been requested by banks or credit card companies recently.
All such inquiries are classified as either “hard” or “soft,” with the former meaning that the query was used to determine whether a consumer qualified for some type of credit. A hard inquiry will knock at least a few points off your credit score for a while, which is a reflection of the belief that seeking new sources of credit makes you more of a risk to other lenders.
Of course, consolidating debts normally involves paying them off with a special-purpose loan or a new credit line. A lender will almost always make a hard inquiry before approving your application, so you can expect your credit score to drop a bit in response.
Fortunately, the negative effects of hard inquiries are generally short-lived. As a result, this temporary, small dip in your credit score should normally not be seen as a reason to avoid debt consolidation.
High Credit Line Utilization Can Lower Your Score, Too
There is another major way by which debt consolidation can negatively affect your credit score. Another of the measures groups like FICO use to compile scores is credit utilization.
Having any of your credit lines nearly maxed out will lower your score significantly. Likewise will a high average utilization rate keep your credit score from rising as high as it could. Installment loans that have not yet been paid down much have the same effects.
Whether you take out a new loan to use for debt consolidation or load up a low-interest card via balance transfers, your credit utilization rates can rise, causing your score to drop. This most often happens to people who are consolidating debts from several cards, none of which were near their individual limits.
On the other hand, debt consolidation can just as easily improve your credit score via the same mechanism. If your utilization of several consolidated credit lines drops overnight, that positive effect can outweigh the negatives.
Debt Consolidation is Often the Most Responsible Choice
While it is true that debt consolidation can lower your credit score, most such effects are minor and short-lived. Couple this with the fact that consolidation can make it much easier to pay off your debts for good, and any negative, temporary effects on your credit score will normally be easy to justify.
You should make sure, though, to use consolidation for the intended purpose and not as an excuse to add even more debt. Responsible consumers quite often find that debt consolidation helps them get back on track even after they have suffered through serious financial difficulties.