Debt consolidation is supposed to help you improve your credit, but what happens if you don’t pay your debt consolidation loan? Delayed payments on your consolidated debt could adversely affect your credit report and significantly lower your credit score.
One of the most common forms of debt consolidation is the use of a personal loan to pay off outstanding credit card balances. The goal is to have one fixed monthly loan payment instead of several variable monthly payments on credit cards. Debt consolidation loans typically have lower interest rates than credit cards, so this transfer can also save you money.
How do you qualify for a debt consolidation loan?
Understanding how a borrower gets approved for a debt consolidation loan can give you insight into the impact of a loan default. Traditional banks, credit unions, and online lenders have approval criteria that include verifying your income, confirming your identification and checking your credit score. The latter is where a default will affect you the most.
Minimum credit score requirements for debt consolidation typically range from 580 to 680. That’s based on the FICO® scoring system. FICO scores are calculated using five primary variables: The most important of those for this discussion are “amounts owed” and “payment history.” Missing personal loan payments can negatively affect both.
Do missed loan payments lower your credit score?
Paying off credit card balances with a personal loan won’t lower the amounts you owe because the loan amount will be equal to the outstanding credit card balances. Your credit report, which is what your credit score is based on, will show on-time payments for the credit cards. That will give your score a boost. Making loan payments on time will increase it further.
Conversely, missing loan payments will decrease your credit score, putting a negative mark in the “payment history” category. If there’s a late fee, that will also increase your “amounts owed.” Additional interest charged for missing the payment will have the same effect — another example of what happens if you don’t pay your debt consolidation loan.
What happens if you miss several payments?
Lenders submit late or missed payment information to the credit reporting bureaus. This could happen monthly, but lenders are not required to submit on any specific cycle. The three main credit bureaus are Experian, Equifax, and Trans-Union. They submit data to FICO to be used in credit score calculations. Missed payments are logged when they are reported.
Whether they report or not, lenders will eventually put an account into collections if you miss enough payments. This will usually happen after four or five missed payments. At that point, the lender may allow you to make a minimum payment to keep the account out of collections, settle the account, or report the collection activity to the credit reporting bureaus.
How long do late payments stay on your credit report?
Each of your late or missed payments will stay on your credit report for up to seven years, but the credit score penalty for them will only be assessed once. That means you can recover from the hit while your credit report still has the information on it. Focus on getting the loan back on track and be careful about how you manage any new credit accounts.
Unfortunately, lenders and credit card companies don’t just look at the credit score. That can be determined by a “soft credit inquiry” that does only a cursory check of your credit qualifications. A “hard Inquiry,” which is usually required for final approval, is a deeper dive into the information used to calculate your score. That will reveal any late or missed payments.
Can you qualify for new credit after a loan default?
Debt consolidation is a strategy designed to make debt more manageable. Defaulting on a debt consolidation loan, particularly if your credit cards were maxed out before taking out the loan, could put up a red flag to prospective new creditors. That doesn’t mean you can’t qualify for new credit after a loan default, but it will definitely hurt your chances.
Waiting a few years before applying for new credit will improve those chances. Credit scores will go up organically over time if the credit bureaus don’t receive additional negative reports about you. It’s also possible to improve your credit score with a secured credit card or credit builder loan. Both should be available, even after a loan default.
Should you take a settlement offer to discharge the loan?
Either the lender or the collection agency they assign your defaulted loan to might make a settlement offer for you to discharge the loan. This is when they agree to take less than what you owe because you can’t afford to pay the whole balance. It sounds like a good deal, but it could have a long-term negative effect on your credit score.
Settlements have their own category on a credit report. Debt settlement companies advertise them as a way to pay “pennies on the dollar” on your outstanding debts but then charge you an exorbitant fee to negotiate that settlement. On top of that, you may also be liable to pay income taxes on the unpaid portion of the loan. Settlement should only be considered as a last resort.
What can you do to avoid loan defaults?
The most obvious answer here is to make all your loan payments on time. Sadly, that’s not always possible. The loss of a job, change in economic circumstances, or personal tragedy can derail the best of intentions. The best thing to do in any of these cases is to contact the lender and ask about your options. Some loan agreements have hardship clauses to protect you.
If your financial setback is temporary, ask if you can defer a payment. This is where a lender allows you to skip the current payment due and move it to the end of the loan term. It won’t be reported as a late or missed payment, so you’ll preserve your credit score. Do this as soon as you know you’re coming up short. Lenders won’t allow it after you miss the payment.