When debt looms, debt consolidation is just one of several solutions. Debt consolidation involves taking out an additional loan with which you pay off some or all of your debts. This doesn't necessarily reduce what you owe, but sometimes you can get better interest rates and monthly payment minimums that are more reasonable given your budget. However, consolidation is not without an impact on your credit. The amount of the impact depends on multiple factors.
The FICO Percentages
To understand how consolidation impacts your credit score, you first must grasp the Fair Isaac Corporation (FICO) method of credit scoring. With this method, factors that impact credit are given a certain percentage, with some factors counting more toward your credit score than others. Your payment history, such as if you've given creditors their money on time, is the largest percentage of your score, comprising 35 percent. The amount you owe, such as $9,000 on a $10,000 card, comes next at 30 percent. The length of your history, which shows how long you've used credit, makes up 15 percent of your score. New credit accounts and the type of credit you use both make up 10 percent.
How FICO Translates Under Consolidation
Consolidation impacts your FICO score primarily under the length of history category. When you get a consolidation loan, you use the money to terminate your debt with your previous creditors. If doing this closes your accounts, then you can truncate your history length. This can impact your credit history negatively. It's best to leave your oldest accounts active, even if you get the balance down to zero.
The other area of FICO involved in consolidation is the new credit accounts, because you have to get a new loan in order to consolidate. Typically, a single new account shouldn't impact your score much, but if you consolidate while you're opening other credit lines, creditors may look at your score and wonder why you're needing so much credit.
Paying It All
In general, paying off a debt in its entirety typically looks good on your credit history. This is what you end up doing with consolidation. For this reason, the more accounts you consolidate, the more consolidation will improve your score, provided you are able to leave the zero-balance accounts open and retain your credit history length.
Program Requirements
Sometimes consolidation companies require you to complete debt management or debt education courses as a stipulation for getting a consolidation loan. They generally just want to make sure you understand the risks associated with the consolidation and have a plan to pay back what you owe the company -- the ultimate goal is to educate you toward better money management. These courses sometimes show up on your credit report. They don't always impact your credit score, but creditors sometimes frown on them, seeing the need for credit counseling as a bad sign. Other creditors see credit counseling as an indication that you've learned the skills you need to handle a debt responsibly.
The Bottom Line
In general, consolidating debt shouldn't have a large impact on your credit, as new credit accounts and length of payment history comprise only 25 percent of your FICO score. Usually, consolidation helps your credit automatically by clearing outstanding debts. However, by the time you look to consolidation, your credit already likely will have dings from missed payments and other issues. Plan to walk a straight financial path after consolidating to preserve the score you have.
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