Loan consolidation is a tool used for debt management. There are several different reasons to consolidate a loan. Some people consolidate a loan in order to have only one monthly payment instead of several. Others consolidate loans in order to lower their monthly payments or lower the interest rate on debts. Loan consolidation can reduce the amount you pay back over time--in the case of a lower interest rate--or it can increase the amount you pay back over time as a lower payment means a longer repayment period. Whatever the reason, loan consolidation can have an adverse effect on your credit score for several reasons.
Credit Scoring
In order to understand why loan consolidation lowers your credit score, it is essential to understand the formula used to calculate a credit score. The formula used by each of the three credit bureaus was pioneered by a company called the Fair Isaac Corporation, and it is called a FICO score. Several factors affect your FICO score, including your payment history, the amount of money you owe, the ratio of your debt to your available credit, the length of your credit history and the number of new credit lines you open. Loan consolidation affects three of these factors: the debt-to-credit ratio, the average length of credit and the number of credit lines you open.
Debt-to-Credit Ratio
Thirty percent of your FICO score is based on the amount of money you owe. One factor that goes into this portion of your credit score is the debt-to-credit ratio. This ratio looks at how much money you owe on a line of credit versus how much money is available to you. For example, if you have a $10,000 line of credit and you borrow $5000, you are using 50 percent of your available credit. The less of your available credit you use, the higher your overall credit score will be.
When you consolidate debt, you generally use one loan to pay off all or some of your debt from several different sources. If you borrow $10,000 to pay off all of your credit debt, then you have used the full $10,000 line of credit available to you from this source. Your credit report, thus, shows you are using 100 percent of this available credit line. If you previously had two credit cards with a $10,000 limit and you owed $5,000 on each, and you consolidate that debt onto this $10,000 line of credit, you have now changed your debt-to-credit ratio from a 50 percent debt-to-credit ratio to a 100 percent debt-to-credit ratio on the new loan. This lowers your credit score.
Average Age of Credit Accounts
Fifteen percent of your FICO score is based on the length of your credit history. This is an average calculated by determining how long ago you opened each of your credit lines. If you take out a new loan to consolidate older debt, this new loan is a new source of credit. Thus, it lowers the average age of your credit history. This also lowers your FICO score.
Inquiries
Ten percent of your credit score is based on the number of new inquiries on your credit report. Each time you apply for a credit card, loan or line of credit, the company pulls your credit report, which means it asks the credit bureau to see your credit report and score. This request shows up as an inquiry on your credit report. A high number of inquiries lowers your credit score because it makes lenders nervous. Lenders do not like people to open lots of new credit cards because it makes them suspect that you are charging up to the limit owed. Although this is not always the case when consolidating debt, and many people do consolidate debt responsibly, it still has an adverse impact on your credit rating to have these new inquiries on your credit report.
Is Consolidating Debt a Bad Idea?
Consolidating debt may be seen by some as a bad decision because of this impact on your credit score. This may be especially true if you plan to make a large purchase, such as a house, within 2 years of taking the consolidation loan. The amount of money you save on interest from consolidating your debt may not be enough to offset the amount of money you will have to pay if your lower credit scores mean you qualify only for a higher interest loan for your large purchase. Furthermore, if you consolidate debt without a careful financial management plan, you may be susceptible to borrowing more money on the lines of credit you made available to yourself by consolidating the debt.
However, debt consolidation can also be a powerful money-saving tool if used properly. Furthermore, the effect on your credit score is not permanent; as you pay off the new debt, your debt-to-credit ratio returns to a lower level. Furthermore, payment history accounts for 35 percent of your FICO score, so if you pay the new loan consistently on time, it can help to raise your credit score.
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