By BHG Financial
Debt consolidation loans have an initial negative impact on your credit score but can raise it over time. Here’s how this works and what to know.
A debt consolidation loan will affect your credit score negatively at first and help increase your credit score positively in the long run, but only if you make your payments on time. The reason a debt consolidation loan will hurt your credit score in the beginning is that the lender will make “hard inquiries” with at least one of the three credit bureaus.
Any time a hard inquiry (also known as a hard pull) is made, it will appear on your credit history with the specific bureau for up to 2 years. These inquiries tend to be less relevant after a few months. The negative impact to your credit score occurs because it can look like you’re in need of money fast and you may not be able to pay the loan back. This is only temporary so don’t panic. Most lenders will expect to see them, especially if you’re shopping around for a new loan.
It’s also important to remember that your total score is made up of numerous factors including how many loans you have, which debts you pay off regularly, and other factors. So, although there is a temporary negative impact on your credit score, it’s just that, temporary.
Now let’s jump into how a debt consolidation loan can have a positive impact and increase your credit score.
By consolidating your debt through a loan, you now have a lower credit utilization ratio. This just means that you’re using less credit than what is available in total. This is only the case if your loan is for a higher amount.
If you currently owe $100 and have a total credit allowance of $200, you have a 50% utilization. If you consolidate your debt and the loan is for $400, your ratio is now 25% instead of 50% meaning you have lowered your credit utilization ratio. That change can have a positive impact on your credit score.
Your credit score will also improve if you pay your debt consolidation loan on time each month. Each payment is reported back to the bureaus and will help increase your score. It is a slow process, but if you keep to it, your score will grow.
One final way a debt consolidation loan can increase your credit score is if your interest rate is lower than the combined interest rates of your past debt. Don’t worry. There’s an example below.
Although the interest rate will not help with your credit score, you’ll owe less money overall and be able to pay it back faster. The lower credit utilization ratio here is what will help increase your credit score.
Suppose you have three debts.
- Credit card 1 – $1,000 at 10% interest
- Medical bills – $1,000 no interest
- Credit card 2 – $4,000 at 20% interest
You owe a total of $3,900.
If your debt consolidation loan is for $6,000 and has a 10% interest rate you now only owe $3,600. By reducing the total amount owed you can pay more money back each month reducing your total debts. The lower debt is what will have a positive effect on your credit score.
That’s how a debt consolidation loan will affect your credit score both negatively and positively. If you’re looking for a loan, click here to read about options available to you as an AAE member.
BHG Financial is an AAE Advantage partner. Learn more at www.aae.org/specialty/member-center/aae-advantage/bhg-financial/ .