How Does Debt Consolidation Impact Your Credit

Key Takeaways
  • Debt consolidation does not automatically hurt your credit score.
  • Loan applications require a hard inquiry, which could lower your FICO credit score by up to five points per inquiry.
  • Addressing your credit utilization through a consolidation loan could positively impact your score once you begin paying on the loan.

The importance of credit can impact decisions as you seek ways to eliminate debt. While high debt balances negatively affect your credit, you may not want to take other actions that further damage your score.

As you explore options for debt elimination, you may consider a debt consolidation loan. Even though loans move debt, rather than paying it off, transferring multiple credit card balances to a single loan can make the repayment process easier and could save you money.

Credit Basics

Debt consolidation loans are one of the few relief options that do not automatically damage your credit. The actual impact depends on several factors.

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Credit card scoring agencies use proprietary algorithms, making it impossible to calculate the impact of any given action with exactness. Scoring companies provide general guidelines that allow you to weigh the impact of certain behaviors.

FICO, the most widely used scoring company, uses the following criteria to create your three-digit score:

Payment history – 35%

Revolving balances (known as credit utilization) – 30%

Length of credit history – 15%

Obtaining new credit (including hard inquiries) – 10%

The mix of credit types (loans versus lines of credit) – 10%

How Debt Consolidation Impacts Your Credit

Hard Inquiries: Debt consolidation loans require an application for new credit, which always results in a hard inquiry. Credit inquiries make up 10% of your credit score and remain on your file for two years. However, FICO only includes it in your score calculation for 12 months.

To help reduce the impact of rate shopping, FICO gives you a small window of time where all applications are viewed as one inquiry. In most cases, inquiries within 45 days will be considered one inquiry for a single loan type. This practice allows you to rate shop for the best deal without significantly impacting your credit score.

Many debt consolidation lenders offer pre-approvals using a soft inquiry, not affecting your credit until you formally apply.New credit applications do not significantly impact your credit but could reduce your score by up to five points for each inquiry.

Closed Accounts: If you choose to close paid-off accounts, it could lower your score. The length of your credit history tracks your oldest open accounts and makes up 15% of your score. Closing accounts can shorten your credit history and increase your utilization, lowering your credit score.

In most cases, debt consolidation loans do not require you to close paid-off accounts.

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Revolving Balances: While credit inquiries have a minimum impact on your score, high revolving balances in relation to the credit limit affect your score almost as much as a missed payment. Under the FICO scoring model, credit utilization (the credit limit versus the balance carried) accounts for 30% of the score.

Paying down revolving balances is one of the fastest ways to improve your credit. Even though a debt consolidation loan does not lower the total debt balances, it does reduce the utilization by eliminating revolving debt with the loan.Converting credit card balances to a fixed loan often positively impacts your score.

Over time, as the loan balance decreases, your credit score will continue to improve. The exception is when you run up new balances on your recently paid-off credit cards. Doing so could significantly damage your credit score and worsen your financial situation.