How Do Consolidation Loans Effect a Credit Rating?

Although a consolidation loan itself doesn't create a huge impact on your credit score, your actions following approval of the loan will determine how your score is impacted. If you do your best to continue paying down the loan while making every effort to avoid using more credit, you will see your score rise. If you continue to grow your debt, your score will be even worse than it was when you took out the loan.

Definition

A consolidation loan is usually an equity loan, meaning your home or something else you own is used as collateral for the money that the lender gives you. If you choose to use a consolidation loan, it will wipe out your balances and you will make just one monthly payment toward the loan rather than payments to multiple accounts.

Pros

If you can find a consolidation loan with a lower interest rate than your current credit cards and loans, and if you are fully committed to paying your debt off, a consolidation loan may help you get out of debt for less money. This creates a positive impact on your credit score in two ways. First, making on-time payments is one of the biggest factors in determining your credit score, so if you pay the lump sum each month your credit will get a boost. Also, once you've paid down your debt, you will positively impact your debt-to-credit ratio, which also adds points to your credit score.

Cons

You must be fully dedicated to paying off your debt and keeping it paid off, or else you will damage your debt further. Of people that take out debt consolidation loans, 70 percent end up with the same amount or more debt within two years, according to Chris Viale, a representative with Cambridge Credit Corporation nonprofit credit counseling agency. This phenomenon occurs because your debts are wiped out by the loan, freeing up credit. By spending more, the debt-to-credit ratio rises, you may fall behind on payments and you could find yourself spiraling deeper into debt. All of these actions force your credit score to sink lower and lower.

Considerations

When you apply for any kind of loan---consolidation loans included---the lender typically submits an inquiry into your credit report. This can create a small negative mark against your credit score. However, if you use the consolidation loan effectively by paying it on time each month and avoiding further contributions to your debt, the boost in your score will outweigh the inquiry.