Many Canadians can find themselves struggling in a vicious debt cycle in today’s financial market. With the burden of multiple credit lines and loans, it becomes really difficult to move towards a sound financial future. With multiple payments due each month, keeping track of all repayments becomes an arduous task. In such situations, the chances of missing a payment are also high, which in turn can lead to a credit score deterioration.
This is where debt consolidation comes into the picture. Not only does this ease your financial situation, but it can also improve your credit score if used wisely. This article will discuss the impact of debt consolidation on your credit score.
What is debt consolidation?
As the name suggests, debt consolidation is a financial method through which you combine several high-interest-bearing loans into a single consolidated loan. This can be done in various ways, such as:
- Credit card balance transfer
- Personal loan
- Home equity line of credit (HELOC)
- Debt management services
Does debt consolidation impact your credit score?
Yes, consolidating your loans does impact your credit score in the short run. However, it also brings the opportunity to improve your score by mending faulty financial habits. Here are some reasons why your credit score dwindles when you take out a debt consolidation loan:
Decrease in the average age of your accounts
Your credit score is impacted by the age of your accounts in your credit report. An old account with a stable repayment history increases your score. A newly opened loan account decreases your average age of accounts. This, in turn, decreases your credit score. When you consolidate your loans, both these events happen simultaneously. You take a fresh loan to repay all your old balances. This has a compounding effect on your credit score, reducing it considerably.
Therefore it is advised not to close all the accounts at once. Pay off the loan with the highest rate of interest, regardless of age. Now out of the remaining accounts, those which were taken more recently. This way, you will be able to retain your old accounts with a low-interest rate on your credit report. This will make sure that there isn’t a dramatic fall in your overall credit score.
Hard credit inquiry
When you seek a loan, the prospective lender usually runs a credit check to check your creditworthiness. Such a check is known as a hard credit inquiry, which is reflected on your credit report. Frequent hard inquiry shows that the borrower has made several unsuccessful attempts to secure a loan. This also reduces your credit score.
Thus, a hard credit inquiry in the process of taking a debt consolidation loan reduces your credit score. However, such hard inquiries only impact your credit score by as low as 10%. But if you have made several hard inquiries on your report in a short period, your score can take a hit.
Credit card balance transfer
A credit card balance transfer is one of the ways through which you can consolidate your loans, wherein you transfer your outstanding multiple credit card dues to a new card offering a lower interest rate. However, there are a few things that must be considered while opting for this solution.
If the limit of your new credit card is less than your existing one’s, you will end up using more of the available credit than before. Higher credit utilization is detrimental to your credit score.
For example: If your current credit card limit is $10000 and you have an outstanding due of $8000, you have utilized 80% of your limit. This is already a high utilization rate which reduces your credit score. Now, consider that you have transferred your existing debt of $8000 to a new card with a limit of $8000. In this case, your utilization becomes 100% of your available credit without an increase in actual debt. This would also contribute to decreasing your credit score.
What is the credit score required for a debt consolidation loan?
There isn’t a one size fits all answer to this question. The credit score required would depend on the mode of consolidation as well as the lender. For example, you would require a Credit score of more than 620 if you are applying for a personal loan. However, you can secure a home equity loan even with a score of 560.
How to improve your credit score post debt consolidation?
Although your credit score takes a hit when you secure a debt consolidation loan, there are ways you can actually improve it. Here is how you can go about it:
- Regular repayment: Since you already have a sizeable debt to repay, you wouldn’t want to miss any scheduled payments. This will only contribute to further decreasing your credit score. Thus, make sure that you make all the repayments on time post-consolidation. Missing a single installment can have adverse impacts on your credit history.
- Do not take out a fresh loan: Your borrower would have run a hard credit inquiry while providing a consolidation loan. Now, if you take out another loan in a short interval, this would lead to another hard credit inquiry. Several inquiries in a short span will reduce your score. Thus, it is advisable not to take out a fresh loan after a debt consolidation loan.
- Opt for a higher limit credit card: If you are opting for a credit card balance transfer, opt for a credit card with a higher limit than your previous card so that your overall credit utilization does not increase.
Endnote
When used correctly, debt consolidation can be an excellent tool to overcome temporary financial difficulties. However, make sure that you modify your financial habits so that you do not find yourself in a debt trap again.
Understanding the implications of debt consolidation can become challenging for a novice borrower. Therefore, it becomes essential to seek professional advice from time to time. Reach out to a finance expert who can advise you on the best course of action. Ensure that you make an informed financial decision to improve your future financial health.
