Missing payments will put a huge dent in your credit score, and if your interest rates are making it impossible to pay down your debt, a consolidation loan may help to ease both of these problems. However, before applying for a consolidation loan, it's vital to understand the risks involved with taking on more debt as a means of eventually paying off your debt.
Definition
A consolidation loan eliminates your current debts by paying them off so that you only have one monthly payment to make under one interest rate. Consolidation loans are most beneficial for those who have difficulty remembering numerous monthly due dates. Additionally, some individuals qualify for consolidation loans with lower interest than their current debts, which lowers the overall payoff amount.
Negative Effects
A consolidation loan impacts your credit score in several ways. First, when you apply for a loan, the lender must make a hard inquiry into your credit report, which creates a small negative effect on your score. According to Smart Money, new credit is calculated into your credit score as well, making up 10 percent of your score, and applying for lots of new credit at once may negatively impact your score as well. Also, a consolidation loan frees up your accounts, so you may be tempted to spend on them. This impacts your debt utilization ratio, the relationship between your debt and the amount of credit available to you, which makes up 30 percent of your score. When you accumulate new debt with a consolidation loan, then contribute to your old accounts by spending on them, your debt utilization rises and your credit score falls.
Positive Effects
Being approved for a consolidation loan does mean that you have additional credit available to you, however, positively impacting your debt utilization ratio. For example, if you had previously maxed out your credit cards at $10,000 and then got a $10,000 loan to cover those cards, you would end up with $20,000 in credit, only half of which you would be using as a result of your debt being cleared out. Also, if you successfully use a consolidation loan to pay off your debt and to keep it paid off, you will see your credit score climb higher as a result.
Considerations
Before taking on a consolidation loan, evaluate your financial situation carefully. Many financial experts believe that consolidation loans are akin to fighting fire with fire, and that alternative routes for debt repayment must be considered. According to a Bankrate article by Jenny McCune, about 70 percent of those who use consolidation loans end up with the same or more debt within two years. Work with a credit counselor to understand your options, such as lowering your existing interest rates or following a stricter budget.
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