If you’re considering how to consolidate credit card debt, you may be wondering if your credit score might take a hit in the process.
The brief answer is that any new loan - whether that’s for consolidating debt or extending your kitchen - is likely to affect your credit score. However, in the long term, assuming you pay off your debt consolidation loan on time, it should have an overall positive effect.
In this article, we’ll explain exactly how your score might be affected, and what you can do to manage any impact.
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What is a debt consolidation loan
A debt consolidation is designed to make it easier to pay off multiple forms of debt. For example, if you have balances outstanding on three credit cards and a store card, you face two issues:
- You’re probably paying quite a high rate of interest on each separate agreement
- You have to manage multiple payments, meaning extra hassle for you
In a case like this, a debt consolidation loan might be a good idea. You take out a personal loan, and use it to pay off your other debt. That way you only have one monthly repayment to worry about, and a personal loan will often carry a lower interest rate relative to other forms of debt, so you might save money too.
They’re often a form of unsecured debt, meaning that you don’t need to be a homeowner or put your property at risk to qualify, although secured debt consolidation loans are also available.
That’s the basics covered, but there’s a lot more information on our page on how to get a debt consolidation loan, as well as a guide to working out when a debt consolidation loan is a good idea for you.
It’s also worth noting that a loan isn’t the only way to do this - there are other consolidation options such as a balance transfer card, which are covered in the link above.
What are the pros and cons of debt consolidation?
Done correctly (see the post we’ve linked to above), a debt consolidation loan has several pros:
- It can save you money (if the loan carries a lower rate of interest than the debt it replaces - although be aware that paying off debt more slowly will cause costs to add up)
- It can make budgeting easier (you only have one monthly payment to worry about)
- It can help you get back on track with debt, giving you a clear repayment plan
- Over the long term, it can help you build up a good credit rating (if you make your payments on time)
There are two main cons:
- Your credit score might be negatively affected in the short term
- If you have a low credit score, you might find it hard to get a loan at a favourable interest rate
In this article, we’ll focus mainly on the issue of how your credit score might be affected by an application for a debt consolidation loan.
How does a credit score work?
When a lender is deciding whether to lend you money, it needs to know whether you represent a good credit risk - basically, whether you’re likely to pay it back or not.
This is a tough thing to know, and running a check on each borrower is difficult. So, many lenders rely on credit bureaus, who gather data on all of us, making life easier for lenders.
That data focuses on your track record of paying back loans (1) (by looking at your payment history for previous agreements) and also covers things like how long you’ve lived at your current address and how much of your available credit you’re currently using.
In general, some actions (such as missing a payment on a loan) will count against you and reduce your score, whereas others (such as paying off a loan on time) will count in your favour.
Related post: Recently moved to the UK? Access to credit can be tough. We wrote a guide on how new immigrants can build credit score to give you all the information you need to improve your odds.
How much does debt consolidation affect your credit score?
There are a few ways in which your credit score might be affected - in general, applying for, and then paying off, a debt consolidation loan will cause a small dip in your score in the short term, followed by an increase as you pay it off.
Short term impacts
There are two ways in which your score can be affected in the short term.
Firstly, shopping around for a loan can result in an impact on your credit score, although it’s complicated. Some lenders carry out what’s called a soft credit search when offering you a quote. This isn’t visible to other lenders, and won’t affect your score.
However, a hard credit search or hard enquiry - which a company might use when you’re making an actual application - does appear on your credit history. A high number of declined hard enquiries doesn’t look good to other lenders, so this might affect your score.
To avoid this, Equifax recommends that “a good way to ensure you protect your credit score when searching for credit is to ask the lender for a quotation first so that you can see the deal they would offer before going ahead and making a formal application”(2).
The other factor is that closing old accounts may negatively affect your score. This is for two reasons - firstly, lenders like borrowers who have kept accounts open for a long time. Secondly, closing credit cards means you have less credit available to you. That means that your credit utilisation ratio (the amount of borrowing available to you which you have used) is likely to drop.
However, you don’t have to close your old accounts - if you prefer, you can keep them open (so that your credit limit is not affected), but avoid using them. More on that below.
Long term impacts
Experian explains that a debt consolidation can have two positive effects over the long term (3).
Firstly, a debt consolidation loan which helps you to pay off loans on time will have a positive effect on your score. Lenders like to see borrowers who are on top of their debt payments when considering whether to offer you a new line of credit.
The second advantage is that a debt consolidation loan could help you to pay less interest, meaning that you can pay debt off faster. Again, that’s likely to improve your score.
How long does debt consolidation stay on your credit report?
The fact that you’ve taken out a debt consolidation loan will stay on your credit report for a considerable length of time - but that’s likely to be a good thing (assuming that you made your loan payments in full and on time).
Hard searches (mentioned above) will be wiped from your credit history after a year.
And if you default on a loan, or make late payments, the record of that event will be wiped after six years(4).
Can I still use my credit card accounts after a debt consolidation loan?
Technically you can - although of course you risk re-creating the problem that you started with. Generally, people use debt consolidation loans as a way of taking control of their finances, with the aim of getting out of debt altogether. Using new debt defeats the purpose, and because it can be so tempting, lots of personal finance sites recommend you keep your credit card accounts open, but cut the cards up. The aim is for your credit card balances to stay at zero.
Can I still buy a home after debt consolidation?
Absolutely, but like any type of loan, an outstanding debt consolidation loan may affect the amount you’re able to borrow. If you already have lots of credit outstanding, a mortgage lender might not be as willing to extend you further credit.
However, since a good debt consolidation loan simply replaces one form of debt with another, this is unlikely to have a significant impact.
How do I get a debt consolidation loan?
If you want to get a debt consolidation loan, the best way to begin the process is by exploring your options. We’ve put together a full guide on how to get a debt consolidation loan to get you started. And if there’s anything else you want to know, leave us a comment below!
Now that you’ve read our article on debt consolidation, you might want to take a look at some of the options available to you. Our loan calculator is a great place to start.