Some people get a debt consolidation loan to try to rebuild their credit scores or to help deal with debt problems. While a debt consolidation loan can help in both areas, it also can hurt your finances and credit scores in some cases. How you handle your debt consolidation loan is the key factor in determining how the loan will impact your credit.
New Loans
Anytime you take out a new loan, you're likely to experience at least a slight drop in your credit score. Credit scores are based on various factors, one of which is the number of new loans you have. If, for example, you take out a debt consolidation loan and open several new credit cards in a short period, your score will likely drop. If you only take out a single new loan, you may experience a slight drop in your score. Another factor in the credit scoring formula involves credit inquiries. Each time you apply for a loan, the lender will check your credit report -- which is called an inquiry -- and that drops your credit score slightly.
Closing Accounts
When you take out a debt consolidation loan, you use the loan money to pay off other creditors. For example, you can take out a home equity consolidation loan to pay off multiple credit cards. Once you pay off those cards, you shouldn't necessarily close the accounts, even though you no longer carry a card balance. Part of your credit score depends on how long you've had your accounts. The longer you've had an account, the better it is for your score. Also, closing accounts affects your credit utilization ratio, which is the amount of debt you carry relative to your available credit (your credit limit). A low credit utilization ratio improves your credit score. If you close your accounts that have zero balances because they are paid off, you are forfeiting a lot of available credit, and, therefore, increasing your overall credit utilization ratio and hurting your credit score.
Decreasing Debt
When you take out a consolidation loan, the key factor impacting your credit score is not obtaining the loan, but your ability to make payments later on. People often take out consolidation loans because the interest rate on the consolidating loan is lower than the rates of the loans that will be paid off. That decreases the amount of your monthly payments. If you take out a consolidation loan and make all your payments on time and use the loan to give yourself increased cash flow by decreasing your monthly payments, you generally improve your score.
Missing Payments
However, if you take out the consolidation loan and start using the extra money to purchase more items, you may quickly fall behind on payments and end up damaging your score. Being 30 days late on a payment can decrease your credit score between 60 to 100 points, according to Yahoo! Finance. If you fall further behind and default on your loan, get sued by your creditor or have your account sold to a collections agency, this will cause even more damage.
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