What Is a Debt Consolidation Loan? Does Debt Consolidation Hurt Your Credit?

Highlights: 

• Debt consolidation is a debt management strategy that combines your outstanding debt into a new loan with a single monthly payment.
• There are several ways to consolidate debt. What works best for you will depend on your specific financial circumstances.
• Weigh the pros and cons of debt consolidation and how it might affect your credit scores to decide whether it's the right path for you.

If you're struggling to pay off multiple debts simultaneously, you might consider debt consolidation. Consolidation can be an extremely useful repayment strategy — provided you understand the ins, the outs and how the process could impact your credit scores.

What is debt consolidation?

Debt consolidation is a debt management strategy that combines your outstanding debt into a new loan with just one monthly payment. You can consolidate multiple credit cards or a mix of credit cards and other loans such as a student loan or a mortgage. Consolidation does not automatically erase your debt, but it does provide some borrowers with the tools they need to pay back what they owe more effectively.

The goal of consolidation is twofold. First, consolidation condenses multiple monthly payments, often owed to different lenders, into a single payment. Second, it can make repayment less expensive. By combining multiple balances into a new loan with a lower interest rate, you can reduce cumulative interest, which is the sum of all interest payments made over the life of a loan.

Debt consolidation loans often feature lower minimum payments, saving you from the financial consequences of missed payments down the line. In short, you'll generally spend less on interest and pay off what you owe more quickly.

Types of debt consolidation

There are several ways to consolidate debt. What works best for you will depend on your specific financial circumstances. These include:

Debt consolidation loan. The most common of these are personal loans known simply as debt consolidation loans. Frequently used to consolidate credit card debt, they come with lower interest rates and better terms than most credit cards, making them an attractive option. Debt consolidation loans are unsecured, meaning the borrower doesn't have to put an asset on the line as collateral to back the loan. However, borrowers will only be offered the best interest rates and other favorable loan terms if they have good credit scores.

Home equity loan or home equity line of credit. For homeowners, it's also possible to consolidate debt by taking out a home equity loan or home equity line of credit (HELOC). However, these types of secured loans are much riskier to the borrower than a debt consolidation plan, since the borrower's home is used as collateral and failure to pay may result in foreclosure.

401 (k) loan. You can also borrow against your 401(k) retirement account to consolidate debts. Although 401 (k) loans don't require credit checks, dipping into your retirement savings is a dangerous prospect, and you stand to lose out on accumulating interest.

Consolidation can certainly be a tidy solution to repaying your debt, but there are a few things to know before you take the plunge.

Debt consolidation loans and your credit scores

Before you're approved for a debt consolidation loan, lenders will evaluate your credit reports and credit scores to help them determine whether to offer you a loan and at what terms.

High credit scores mean you'll be more likely to qualify for a loan with favorable terms for debt consolidation. Generally, borrowers with scores of 740 or higher will receive the best interest rates, followed by those in the 739 to 670 range.

If your credit score is lower than 670, debt consolidation may not be a good option for you. Consolidating debt when you have bad credit can be challenging. Although you may be approved for a loan, the interest rates offered to you will likely be high and may negate the savings you hoped to achieve by consolidating your debt.

It's also important to understand that debt consolidation involves taking out a new loan. As with any other type of loan, the application process and the loan itself can affect your credit scores. Weigh the pros and cons of debt consolidation and how it might affect your credit scores to decide whether it's the right path for you.

Pros

• Credit Utilization. Your credit utilization ratio, the amount of revolving credit you're using divided by the total credit available to you, contributes to your credit scores. Lenders interpret high credit utilization ratios (usually above 30%) as an indicator of risk. So, if you have several credit cards open and each is carrying a large balance, your credit utilization ratio will be high, which typically translates to lower credit scores. However, credit cards and personal loans are considered two separate types of debt when assessing your credit mix, which accounts for 10% of your FICO credit score. So if you consolidate multiple credit card debts into one new personal loan, your credit utilization ratio and credit score could improve.
• Payment History. If you have been struggling with high-interest debt, you already know that missed payments can quickly drag down your credit scores. Debt consolidation offers a solution: if you are able to obtain lower interest rates and lower payments, then it may be easier to meet your monthly obligation and avoid a negative hit to your credit scores.

Cons

• Hard Inquiries. When you apply for loans, including those for debt consolidation, potential lenders review your credit reports, which generates what's known as a hard inquiry. Hard inquiries help lenders track how often you apply for new credit accounts. Each new inquiry may knock your credit scores down a few points, so you'll want to be sure that you only apply for loans for which you're likely to be approved.
• Newer Accounts. The average age of your accounts has a big impact on your credit scores. Opening a new account will lower the average age of your accounts, and you might see a corresponding drop in your credit scores. Closing credit accounts that have been paid off will generally have the same effect.

Alternatives to debt consolidation

Consolidation isn't the only option for debtholders looking for relief. Consider these alternatives:

Debt management plans. Some non-profit credit counseling services offer debt management programs, where counselors work directly with the creditor to secure lower interest rates and monthly payments. This approach may help you avoid taking out a new loan, but there's a catch. You'll also lose the ability to open new credit accounts as long as the debt management plan is in place.

Credit card refinancing. Credit card refinancing involves transferring your debt onto a new balance transfer credit card with an interest rate as low as 0%. This introductory rate is only temporary, however, and these kinds of cards are difficult to get without good credit scores.

Bankruptcy. Filing for bankruptcy is a legal process for individuals and businesses that find themselves unable to pay their debts. During bankruptcy proceedings, a court examines the filer's financial situation, including their assets and liabilities. If the court finds that the filer has insufficient assets to cover what they owe, it may rule that the debts be discharged, meaning the borrower is no longer legally responsible to pay them back.

While bankruptcy can be a good choice in some extreme situations, it's not an easy way out. Bankruptcy proceedings will have a severe impact on your credit scores and can remain on your credit reports for up to 10 years after you file. Bankruptcy should generally only be considered as a last resort.

Juggling multiple debts can be overwhelming, but it's important not to let those bills pile up. With a few deep breaths and some careful consideration, finding a strategy for debt management that keeps your credit healthy is well within your reach.