What is Debt Consolidation?‘Does Debt Consolidation Ruin Your Credit?’

Before the coronavirus pandemic, financial experts typically recommend people to prioritize debt payoff first. However, today over 36 million Americans are unemployed; the priority has shifted to savings.

It is very essential to have an emergency savings account. And whereas financial advisors recommend you to stash expenses in a high-yield savings worth anywhere from three to six months’ worth, having at least $1,000 saved is an excellent place to start. However, it is challenging to know what goals to prioritize if you have got a lot of credit card debt and fewer savings.

As far as you make your minimum payments on time, your credit score will remain in good shape, and saving will help you prepare for financial surprises ahead, like getting laid off, being furloughed, and losing revenue.

Nonetheless, credit cards have the highest interest rates out of each type of credit product. If you have recently decided to stop prioritizing paying off your lingering credit card balances so that you can pad your savings instead, you might end up paying a huge amount in interest in the long run.

One remedy is to use a personal loan via LightStream, SoFi, or payoff to consolidate your credit card debt into one monthly payment. This often results in lower interest and can assist you to interrupt the debt cycle for good.

Here we explain what debt consolidation is as well as what to bear in mind when deciding whether to consolidate your debt.

Debt consolidation definition, and how does it work?

Debt consolidation often means taking out a loan to pay off existing debts, and most commonly, credit card debt.

These are technically personal loans that lenders usually market as debt consolidation loans, which is not inaccurate; it is just their way of allowing you to know how they can assist you. You will take out the loan, receive the funds, and use them to pay off your credit card balances. Then you will repay the loan over time like any other loan.

You can also consolidate with a balance-transfer credit card or other types of loans, like a retirement account loan or home equity loan. Nonetheless, personal loans typically have the benefit of no collateral requirement and lower interest rates.

People with a lot of high-interest debt have a tendency to look to consolidation since it simplifies repayment and can minimize the cost of the debt through lower monthly payments, lower interest, or both.

What are the pros of debt consolidation?

  • Debt consolidation can boost your credit score
  • You can potentially owe less monthly with debt consolidation
  • Possibly get a lower interest rate
  • Replace a lot of monthly payments with just one

What are the cons of debt consolidation?

  • With debt consolidation, you might pay fees over time or upfront
  • Your payment can be larger than minimum credit card payments
  • You will owe a huge monthly payment, rather than several spread over the month
  • Some mistakes can hurt your credit score ( we will discuss what to avoid below)
  • The debt may cost you more over time

What is the best option for debt consolidation?

5 Alternatives to Debt consolidation loan 

You may come across companies providing one of several ways to solve your debt. They will each have a different impact on your credit score and apply to various situations:

  1. Consolidation: This is where you combine several debts into one. A single credit card or loan pays off the balance on several others, so you are justify with just one line of debt. Consolidate debt when you need to streamline repayment of various debts.
  2. Refinancing: This works like consolidation; however, the term often refers to paying off a single debt. You cover one loan with a new loan that offers you better repayment terms and interest rates. Refinance your debt if your finances and credit have improved since you borrowed.
  3. Settlement: In this case, you agree with a creditor on a reduced repayment amount that will consider payment in full. This will show on your credit report and can hurt several years; however, it will help you pay off the debt faster.
  4. Debt relief: This is an umbrella that incorporates refinancing and consolidation, and it often incorporates some amount of debt forgiveness. The term is frequently used by organizations that facilitate debt consolidation or debt management plans- you are best off managing the debt on your own and doing a little research.
  5. Restructuring: This is more common for organizations than individuals and often happens in dire situations. The impact is similar to refinancing; however, it involves reorganizing the existing debt instead of replacing it with a new one.

Do I need a good credit score for a debt consolidation loan?

You do not necessarily require a high credit score to take out a loan for debt consolidation; however, better credit gives you a better chance at favorable terms and a low-interest rate.

Look out for predatory lenders if you have a low credit score; some unscrupulous organizations are willing to offer you a loan you can not afford with a very high-interest rate. A loan you cannot afford to repay can put you in a worse situation than the one you are in a credit card debt.

How debt consolidation affects credit scores?

Consolidating debt can help your credit score in two major ways:

  • A positive line on your credit record: The loan is a way to portray your creditworthiness as far as you stay current on payments.
  • Reduce your credit utilization: The amount of available credit you use weighs consolidation pays off those balances and decreases your utilization.

Consolidation itself does not leave a negative mark on your credit history like debt settlement does. However, the loan (or credit card) shows up a new credit line, which can temporarily reduce your score.

How to consolidate credit card debt so that it can boost your credit score?

A few common debt consolidation mistakes can hurt your credit score or cost you money. Below are tips to make the right decision for your case.

Do not close the paid accounts

Once you pay off credit cards, do not close every account. Having them on your credit history impacts these factors that make up your credit score:

  • Utilization: Many credit cards open means more available credit. Reduce your cards to avoid growing that balance again, and that unused credit will keep your utilization ratio low.
  • The age of credit history: Lenders want to see you have been around the block with credit. Once you close old cards, your average credit history gets shorter.
  • Credit mix: This depicts the types of debt you have, such as installment loan versus credit card mortgage. It has a small but significant impact on your credit score.

Keep up with payments

Your balance-transfer credit card or credit card consolidation loan is still debt with monthly payments you have to keep up with.

Create a budget before you take out the loan so you are aware of what you can afford the monthly payment. Staying on top of the payments can help your credit score over time- but getting behind will harm you.

If you opt for a balance transfer card, which often comes with an introductory zero percent APR for about a year- plan to pay the debt off during the introductory period. Any longer, and you possibly face annual fees and a high-interest rate.

Compare consolidation options

Before you commit yourself to any debt consolidation option, shop around. Consider what type of consolidation- secured loan, balance-transfer card, and personal loan works best for your based budget, existing debt, and creditworthiness.

Online loan marketplaces can assist you quickly see and compare personal loan offers from creditors side by side. To assess a debt consolidation loan, consider:

  • Interest rate: The purpose of an interest rate that is lower than the mixed rate on your existing debt. A loan with a higher rate can give you the relief of a lower monthly payment and lesser creditors; however, it will cost you more money.
  • Fees: Go through the fine print to comprehend the total cost of consolidation. A personal loan may have an origination charge, and a balance-transfer card may charge an annual fee after the first year.
  • Monthly payment: Reorganizing your debt to get a smaller monthly payment can outweigh the long-term savings you would get with lower interest or a shorter repayment term. A smaller bill can make the difference between paying on time or not, which has a major influence on your credit score.
  • Repayment term: The more time you have to take to repay the debt, the smaller your monthly payment will possibly be- and the more time the balance will have to accumulate compounding interest, the more money will cost you over time.

Set up an emergency savings fund

Whichever plan you choose to consolidate your debt, separately build up a cash reserve or an emergency fund that you can use in the future to avert falling back into credit card debt.

You will need to build up cash in a savings account that you absolutely do not touch unless it is a real emergency—no dipping into it to cover a big shopping spree or take a vacation. Typically, experts recommend that you save three to six months’ worth of expenses in your emergency account.

Refinance again in the future

Maybe your best alternative now is to take out a loan at a high-interest rate and a long repayment term. If that puts you on track with debt payments, it can be what you need to boost your credit score. Do not stick yourself with those bad terms for the long haul.

As your score increases and you get a handle on your monthly budget, consider refinancing the loan to better terms.

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