When you have trouble keeping track of your debts or making payments, consolidation sometimes is an option for getting control over what you owe. Like other methods of handling debt, debt consolidation can impact your credit score negatively if you do not approach it the right way. The goal of consolidation, however, is always to bring up your score.
What Is Debt Consolidation?
Companies that work with debt often use the term "debt consolidation" to refer to debt management or debt counseling, which leads to confusion about whether consolidating dings credit. Debt management involves getting a middleman to negotiate for you and pay creditors out of a lump sum you provide. Debt counseling is just advice, which doesn't hurt your credit as long as the advice is good.
True debt consolidation involves taking out a new loan. You use the money from this loan to pay off your old debts. Once you've done this, you have just one payment to make to your consolidation loan lender, which makes working with your debt much less of a hassle. When you consolidate, you typically get a lower interest rate overall than you were paying on your individual old debts, and you can negotiate your term length so you pay less every month than you would if your loans weren't consolidated.
How Consolidating Helps Your Credit
When you consolidate, you open a new line of credit. New lines of credit account for about 10 percent of your credit score. The biggest impact to your score comes through your payments to the new lender and your credit history; payment history and credit history length together account for half of your credit score. When you consolidate and pay off the old lenders, your old accounts are marked as "paid in full," the highest status possible. There is no chance of making late payments on these accounts. Provided you keep your old accounts open after you pay the balances off, consolidation gets your accounts in excellent standing while maintaining your credit history.
How Consolidation Lowers Your Score
Consolidation can hurt your credit in that you lower your credit utilization ratio. This ratio is the amount of credit you're using divided by the amount of credit your lenders will give you. You have to have some credit utilized in order to keep building a payment history, so even though you want to pay what you owe, you don't necessarily want to drop your credit utilization ratio to zero. Your credit score will take hits if you close the accounts you pay off because account closure typically trims your credit limit. Your score also may decrease if you miss payments on the consolidation loan. You also shouldn't apply for new credit more than once in six months. The Fair Isaac Corporation, the company that establishes credit scores, typically sees the opening of many new accounts within a short period as a signal of financial trouble, so your score typically drops if you try to consolidate soon after getting other new lines of credit.
Bottom Line
Consolidation does have the potential to lower your score. However, as long as you pay attention to when and how often you consolidate, don't close the accounts you pay off, and are consistent about your payments, consolidation should make your credit score go up overall. Consolidation is much better for your credit than other forms of debt reduction, such as bankruptcy or debt management.
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