How Does a Debt Consolidation Affect Credit Rating?

What Debt Consolidation Is

Debt consolidation normally come in two flavors: a debt consolidation loan and a debt management firm. Both of these solutions will lump a consumer's debt into one neatly wrapped, and often lower, monthly payment. However, deciding between the two can have an impact on your credit report and credit rating---both in the short and long terms. So before choosing a debt consolidation method it's best to know what you are getting into.

Debt Consolidation Loan

Debt consolidation loans can either be in the form of a home equity loan (in which you borrow against your home's value) or a personal debt consolidation loan, with no collateral. Initially, borrowing this money will bring your credit score down by a few points, as it will heighten your debt-to-income ratio. However, as balances begin to be transferred from creditors into your debt consolidation loan, your credit score will improve. And as you make timely payments toward your debt consolidation loan your credit score will not be negatively affected.
There are a couple of points to remember in all of this, though. Closing credit card accounts or personal loans after placing them under the debt consolidation umbrella can have a negative impact on your credit score, as this can appear to creditors as if you do not know how to manage your money properly.
Another damaging factor can be applying for additional credit shortly after obtaining a debt consolidation loan. It can be considered a negative if a consumer is applying for credit more often than once every six months.

Debt Consolidation Company

Debt consolidation companies do not loan money. Their function is to negotiate with creditors on your behalf in order to lower or freeze interest rates, and then to create a single, affordable payment. In this scenario, you pay the debt consolidation company each month, and they disburse the payments accordingly to each of your creditors.
What does this do to your credit score? Nothing good. Since these debt consolidation specialists are settling with your credit card companies to pay less than what you owe, this doesn't look favorable to banks or lenders and will decrease your score. The debt management company will also have a flag placed on your credit history, alerting potential lenders that you have consolidated your debts, which reduces your chances for getting a loan approval.
In many instances, the creditor will close your account after payoff, further damaging your credit score. While the convenience of a debt consolidation company may seem attractive, it's important to note that unless you are behind on payments the firm might not offer the best opportunity to keep your credit history in the black.