Does debt consolidation affect credit rating? It’s a common question, and the simple answer is yes, your score can be negatively affected when you take out a debt consolidation loan. The impact, however, may be outweighed by the benefits of the loan. What’s more, the drop in your score will likely be reversed by making your loan payments on time.
Taking full advantage of a debt consolidation loan’s advantages can require some education, plus adopting new financial habits to get your money management on track. So read on to learn the details on how your crucial credit score is determined, how debt consolidation can impact your three-digit number, plus tips on keeping your score in as good shape as possible.
How Does the FICO® Scoring System Work?
Before answering “Does a debt consolidation loan lower your credit score,” let’s have a quick session on how credit scores are calculated. Several agencies have credit scoring models, but the most popular with lenders is FICO®. These scores can be used to determine the creditworthiness of a prospective borrower or credit card applicant. Often, the higher your score, the better the interest rate you’ll be offered on a line of credit.
A FICO® score is a number between 300 and 850. Anything under 580 is considered “poor” credit by lending institutions. Scores over 800 are rated as “exceptional.” The levels between those two extremes are Fair (580-669), Good (670-739), and Very Good (740-799). FICO® scores are calculated using the following five variables:
- Payment History (35% of score): This is the most important variable because it’s the one lenders care about the most. Do you make your monthly debt payments on time? A history of getting payments out before the due date will gradually increase your credit score. Late or missed payments will typically result in a lower score.
- Amounts Owed (30% of score): There are two dimensions to this variable. The first is the total amount owed in debt. The second is the amount of debt owed versus the amount of debt approved, also known as the credit utilization ratio. Another way to think of this is how high your balance is vs. the credit limit on an account. Not surprisingly, people with higher FICO® scores usually have lower credit utilization rates.
- Length of Credit History (15% of score): This reflects how long you’ve been using credit, and longer histories tend to inspire more trust. This factor counts as 15% of your overall FICO® score, and it’s why financial experts often advice that you never fully close your first credit card account. That’s the debt that sets the “length of credit history.” Closing it resets the history to show your next oldest account, shortening the total credit history.
- Credit Mix (10% of score): Loans and credit cards are two different types of debt. Auto loans, mortgages, personal loans, and lines of credit are also different. Having a good “credit mix” is a sign of financial maturity. Lenders and credit card companies look at that before approving you for any type of new debt.
- New Credit (10% of score): Opening a new account or applying for one will appear as “new credit” on your credit report. That can cause your FICO® score to drop a few points, but the effect will be temporary. Make your debt payments on time, and you’ll see a credit score increase within a few months.
How Does Debt Consolidation Affect Credit Rating?
The variables for calculating a credit score are affected every time a consumer makes a debt-related transaction. Let’s look at how a debt consolidation loan could change your number:
- A debt consolidation loan will be categorized as “new credit.” This could lower your credit score by a few points for a short period of time.
- A debt consolidation loan could also add to your “credit mix” if you haven’t taken out a personal loan before. This could increase your score.
- “Length of credit history” won’t be affected by a debt consolidation loan because you already have existing debt accounts that were opened earlier.
- “Amounts owed” will, however, be increased because you’re taking on new debt. This tends to lower your score.
- Now, we’re at that most important factor: “payment history.” That could increase or decrease depending on how vigilant you are with your monthly loan payments.
Ultimately, the effect of debt consolidation on your credit score is determined by the behavior of the borrower who takes out the debt consolidation loan, i.e. determined by you. Paying off existing debt and making loan payments on time will have a positive impact. Missing payments or paying late will have a negative impact. That seems simple enough, but there’s more. Keep reading.
The “Credit Trap” of Debt Consolidation
Does debt consolidation affect credit rating in a bad way if you make all your monthly loan payments on time? The answer would be “no” if this were the only factor in play.
Unfortunately, there’s also human behavior. Paying off all that credit card debt with a debt consolidation loan may give you lots of extra spending bandwidth. That’s commonly known as a “credit trap.”
Think about it this way. Your credit card, which you haven’t been able to use for some time, suddenly has an available balance of several thousand dollars. You haven’t been shopping in a while. One small purchase can’t hurt. Right? Guess again. For debt consolidation to truly work, you must change the behavior and pay for all your purchases in cash (or with your debit card).
Far too many consumers borrow money to pay off debt and then, once the stress has eased up, start spending again. Before long, the “amounts owed” used by FICO® to calculate your credit score have doubled. That leads to lower credit scores and an inability to borrow again when you get into financial trouble. Debt consolidation isn’t the culprit here. Consumer behavior is. So be prepared to really dig in and shift how you spend if you want to wrangle your debt this way. Or perhaps you will also investigate ways to boost your income to cover your cost of living. Side hustles and working for, say, rideshare companies are popular ways to do that.
The Bottom Line: Debt Consolidation Affects Credit Scores
Does debt consolidation affect credit rating? If you’re still asking that question, you’ll want to go back and reread this article. The debt consolidation loan itself has only a small impact on your FICO® score. It may go down a few points when you get approved because your “amounts owed” will increase. It also counts as “new credit.” That could make your score go down too.
The behavior of the borrower (that means you!) is what can improve or damage a consumer’s credit score. Ultimately, it comes down to making payments on time, but you’ll also want to change some spending behaviors to ensure you don’t fall into the same trap again. That’s a commitment you’ll want to make before taking out the loan. Consider it carefully. Ready to spring into action? Tap your will power, and get set to make the most of this financial tool. You may emerge all the better for it.