Does Debt Consolidation Affect Credit?

If no one wants to deal with all the bills, consider consolidating your debt.
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Think of debt consolidation as a game; the goals are becoming debt-free and achieving a high credit score. As with most games, there are strategies and rules. If you play by the rules and use a winning strategy, you reach your goals. If not, you could lose and wind up with an even larger debt problem and a lower credit score.

What It Is

Debt consolidation means moving all those messy, hard-to-keep-track-of debts you have into one big debt. The idea is that one debt is easier to keep track of, and if you play your cards right, you will save you money by cutting down or even eliminating the interest you pay. Typically, you consolidate debt by taking out a debt consolidation loan, a home equity loan, borrowing from your 401(k) or transferring your balance to a low- or no-interest rate credit card.

How You Lose

Watch out for the debt consolidation loan. If you need one of these in the first place, it probably means that you have too much debt and that your credit is shaky. If so, the interest rate you get will not be prime. In fact, it might be higher than what you currently pay. If that’s the case, don’t take one, or you lose by paying more in interest. If you take out a home equity loan and miss the payments, you can lose your house. When you borrow from your 401(k), you lose by tapping your retirement, and if you change jobs, the loan becomes due immediately. If you can’t pay it back, you pay a 10 percent penalty. Balance transfers to a low or 0 percent credit card have all sorts of traps. The low balance you get in the beginning doesn’t stay low for long, and when the rate adjusts, you could be paying more interest than what you were paying before. And by opening a new account every six months to beat the rate hike, your credit score takes a hit.

Your Credit Score

If you miss a payment on your credit card balance transfer, all bets are off. You lose the low interest rate, and you get a hit on your credit score. Payment history affects your credit score more than anything else. Credit card balance transfers have the added problem of messing with your available credit. When all your debt is on one card, you are probably using all of that card’s available credit, or close to it, which lowers your credit score. Available credit is the second biggest factor that determines your credit score. Applying for new credit often can hurt your credit score, too, which is what you do by transferring your balance from credit card to credit card to take advantage of a low rate. At some point, a credit issuer may deny you credit based on your falling score, and then you pay high interest rates again.

How You Win

Your best strategies to win the debt consolidation game are to take out a home equity loan with a low interest rate, which also offers you a tax break, and make regular payments, or to take out a debt consolidation loan if you can get a good interest rate. With both strategies, you are not playing the risky credit card balance transfer game, and you are not maxing out your available credit. By taking out a home equity loan or a debt consolidation loan, you will have a manageable way to pay your debt without messing up your credit score. In fact, by making regular payments and knocking out your debts, your credit score will go up.

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