Are Debt Consolidation Loans Bad for your Credit?

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Dan Steadman

Financial Advisor, DCL

Are Debt Consolidation Loans Bad for your Credit?

Millions of Americans are drowning in debt.  Many of us are working more and making less, which can make it difficult to get ahead of your expenses and actually save money instead of scraping by from check to check. If you are thinking about consolidating your debt, chances are, you have a lot of questions. One question many consumers ask is if consolidating their debts will damage their credit score.

The answer to this question really depends on you. A debt consolidation loan does not necessarily automatically hurt your credit score in most cases.

Choose a Reputable Company

First, you want to make sure you are using a trusted company to handle your debt consolidation. Some companies may only offer a debt consolidation loan if your accounts are considered delinquent. Obviously, if you choose this route and become delinquent on your accounts, this will damage your credit score. In addition, the debt consolidation company may be responsible for making the payments to your accounts on your behalf.  There are many issues that can arise out of this type of debt consolidation loan and payment plan.

If the lender does not make the payments or makes the payment late, you are responsible for that late or non-payment, and this will also negatively affect your credit score. Some debt consolidation companies will only pay one account off at a time, so all the other accounts that continue to be delinquent will also be reflected in your credit score and cause it to dip down extremely low. In addition, if the company closes out all of your accounts, this can also affect your utilization and makes it difficult to re-build your credit by maintaining your account.

Are Debt Consolidation Loans Bad for your Credit?

The Key: Getting a low interest rate

A debt consolidation loan will only work to reduce your debt if you have a relatively low interest rate. Again, it is important to find a reputable debt consolidation company who has proven success in helping people overcome their debt and successfully utilize the company’s debt consolidation loans or offers. A non-profit credit counseling company may be a good option to consider – they do not make any money off you or your account holders. Many times, these non-profit organizations offer debt management plans to help you consolidate your debt and pay it off as quickly as possible. We will discuss debt management plans a little later.

If you are already struggling just to make the minimum monthly payments to your creditors, you may already have a relatively low credit score.  If not, and you have good credit, you will have a better chance getting a low interest rate on your debt consolidation loan. Those who may not have good credit may have a more difficult time getting that low rate – but it can be done (or at least, you can get a reasonable rate that will still benefit your finances).

You have several options to choose from if you are looking for the lowest interest rate for your debt consolidation loan. Start with your bank or credit union to see what they have to offer for debt consolidation.  It is important to know the monthly payment plan and term in order to compare plans and interest rates. LendingClub.com and other similar online lending organizations are also another option to consider when looking for a debt consolidation loan.

Warning: While some online lenders are legitimate, others are scams! Be aware of any deal that sounds too good to be true, and be sure to do research on the company before you sign any kind of agreement with them.

If you choose a legitimate lender and you get a relatively low interest rate on the debt consolidation loan, you can actually use this as a way to improve your credit score, if you use the loan to pay off credit card debt on cards that are near the maximum limit. It is possible to have your credit score lower due to getting a debt consolidation loan, but then once you begin to reduce your credit card balances, your score will go back up.  You may have to be patient, but it is possible.

Be Responsible with your Debt Consolidation Loan

A debt consolidation loan can make it easier to manage your debt. If you get a loan that has a lower interest rate than your credit card accounts currently do, then you are on the right track.  Instead of several smaller accounts with higher interest rates, you can reduce your payment into one single amount.  This can make it easier to make the payments on time, which will lead to an improvement in your credit score.

During this time, you should not attempt to open any new credit card accounts.  The goal for your finances should be to remove the debt and then live within your means so you only need to use a credit card in an emergency.  Only after you repay your debt consolidation loan should you consider applying for a credit card.  If possible, build up your savings account so you can rely on that in an emergency and avoid credit cards altogether.  This can make a huge impact on your financial success.

Immediately after your debt consolidation, your credit score may dip significantly, but you shouldn’t be alarmed. The amount your credit score lowers depends partly on how many credit card or debt accounts you have open.  The more accounts you have, the more accounts you have in default, which will categorize you as a high credit risk.  Once you begin to pay down those accounts and they are completely paid off, your credit score will reflect that and will rise. If you make your monthly consolidation payments on time (which should be your only payment other than household expenses), your credit rating will be higher than it was before you obtained the loan.

The Benefits of a Debt Consolidation Loan

A debt consolidation loan is a good option to consider to help manage your debt and finally get relief from barely making the minimum monthly payments on your credit cards or other debts. It can lower the interest rate you are paying and it can combine all those different payments in a single monthly payment. If you do not get a lower interest rate, or you can’t afford the debt consolidation loan payment amounts, you are not on the road to reducing your credit score. In fact, you may find yourself in an even worse financial situation than before you used a debt consolidation loan.

You should also consider how long it will take you to repay the debt consolidation loan in full and finally have financial freedom. The longer the loan term, the longer it will take to pay off and the more interest you will end up paying. Remember, during your loan repayment you should not be using or opening any credit card accounts.  This will not help your credit score and it may lead to another situation where you can’t afford your monthly minimum payments.

Lowering or eliminating your debt can have a significant impact on your credit score, in a good way! Most consumers in the high credit score range (785 and above) have only a few credit card accounts with extremely low balances.  Creditors want to see that you can handle your debt responsibly and make more than the minimum monthly payments to reduce your account balance.

Regardless of the option you choose to reduce your debt, the outcome should be the same. Whether you choose a debt consolidation loan or a debt management plan, or you make your own plan and put every dollar you can toward paying off your debt, the end goal is to lower or eliminate your debt.  This will result in a higher credit score over time, no matter which path you choose to get there.

Don’t Fall Back into the Trap!

If your accounts remain open, it is essential to use your credit cards responsibly once you have paid down your debt. You do not want to end up in the same situation you were in before you took out the loan or repaid the debt on your own with sacrifice and determination. If you need to, cut up all your cards so you can’t just pull one out of your wallet and use it. If you have an emergency, you can get your account number and request a new card.

You should have a budget or a financial plan and stick to it! The only way to successfully maintain your increased credit score and your financial well-being is to begin using credit cards responsibly, or not using them at all. Remember how you feel now, with all this debt looming over you.  Make a promise to yourself that you will never get into this situation again, and plan accordingly.  Perhaps you have a hobby or past-time that you can turn into a second income, or find ways to cut your expenses.

Once you pay off your debt, you should have a budget that includes putting money into a savings or emergency fund account. If you add a little to it every payday or every month, it will continue to grow and give you a little breathing room.  You should budget all your expenses and include unexpected items such as car repair or medical bills.  Once you have a budget that works for you, be sure to follow it.  It may be old over time, but you have to remember why you are doing it.

Debt Management Plans

It is important to understand that a debt management plan is not a loan. Most debt management organizations work with creditors on your behalf to reduce your monthly payments while eliminating extra fees and charges.  This type of plan typically has a term of anywhere from 3 to 5 years in order to pay of your debt entirely. Most non-profit debt management companies have different options to help people overcome their financial difficulties while also reducing their unsecured debt.

With a debt management plan, you make payments to the non-profit credit agency, and they turn around and make the payment to your creditors at a reduced rate and monthly payment amount. This can negatively affect your credit if you have to close all of your accounts, as many debt management plans require. In this case, your score can go back up once you pay off your debt, because your credit score will not reflect the payments you are making through the debt management plan organization.

The advantage of a debt management plan is that the credit agency will make sure the monthly payments are an amount you can afford, and they also consider your household income and expenses when determining a payment amount. In addition, it will put an end to the non-stop calls from your creditors, and it allows you to have one payment instead of paying each creditor individually.

Unsecured debt

Unsecured debt is any debt or obligation that is not protected or collateralized. Basically, unsecured debt is any debt that does not have collateral, such as student loans, medical bills, and credit cards.  A mortgage or car loan is secured debt, because the house or the car is the collateral – if you fail to pay, your house or car can be taken as payment for the debt. Not a fun situation to be in.

A debt consolidation loan can lead to a rise in your credit score if you use the loan responsibly.  Be sure to get an interest rate lower than what you are currently paying, make the monthly payments on time, and do not use or open any credit card accounts while you are repaying the loan. If you think a debt management plan is your best option, it is important to understand that you will be closing all of your accounts and those accounts will remain in default until the account is paid in full through the debt management plan.

 

Dan Steadman

Dan Steadman

Financial Advisor, DCL

Dan is one of the top financial experts when it comes to debt consolidation. With more than 20 years of experience helping people tackle debt, he has a unique insight when it comes to solving debt-related problems. 

Dan got his start when he went to work for a bank after getting his Business Degree. He worked his way up and became a loan officer. This position gave him unique insights into the ways that financial products work and how people can utilize different financial products to improve their lives. He’s seen hundreds of success stories and just as many failures – so he knows what steps are most likely to help his readers.

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