Do Consolidation Loans Hurt Your Credit?

Ask around, and you might get the idea that debt consolidation loans are complicated. Google says it could make loans simpler and cheaper and…damage your credit score? 

Feels like a catch-22. But the truth is a lot simpler than it appears. Credit score algorithms are complicated and can seem unpredictable, sure, but you do have control over your financial health.  

A debt consolidation loan might boost or ding your credit score right away, depending on your current credit situation. In general, a consolidation loan could be worth it if it improves your financial situation, regardless of credit score impact. 

Let’s look at the main ways debt consolidation could hurt or help your credit score—and when consolidation is worth it despite score changes.

How Debt Consolidation Affects Your Credit

How a debt consolidation loan impacts your credit varies, with the short- and long-term impacts potentially turning out differently depending on your current credit profile.

At first, your credit score might see a bit of a ding. The hard inquiry from applying for a new loan could bump it down a few points for up to a year. Plus, your average account age drops when you add a new credit account.

But when you use a consolidation loan to pay off credit card balances, your credit card utilization ratio usually improves, possibly offsetting any immediate negative impact to your score from the other factors.

And there are other, bigger factors to consider. The most important one is probably: What next?

Regular on-time payments have the largest long-term impact on your score. Making your loan payments on-time every month could help your score over time. So, too, could adding an installment loan to your credit mix if you've only had credit cards until now. Here's a deeper look at how consolidation could help your credit scores.

Ways Debt Consolidation Could Help Your Credit

Debt consolidation could improve your score by improving a few FICO Score metrics: amount owed (25%), payment history (35%), and credit mix (10%).

Lower credit utilization

Credit score calculations look at your amounts owed, typically by way of your credit utilization. This is a measure of how much of your available credit you're using.

FICO treats revolving debt, like credit cards, differently than installment debt such as a personal loan. High credit utilization on your revolving debts negatively affects your score. Installment loan balances don’t affect your credit the same way. 

For example, say you have $8,000 spread across two cards with a combined $10,000 limit. You consolidate some of that debt into a $7,000 personal loan. You leave $1,000 on your credit cards. Your credit card utilization drops from 80% to 10%, potentially boosting your score. 

Streamlined payments

Consolidation often simplifies payments by combining multiple debt payments into one new loan payment. It’s less work to track, and you could be more likely to remember payment due dates. 

Making payments on-time has the biggest single impact on your credit score. So, even a single late payment could severely ding your credit scores. A late payment remains on your report for seven years. 

Credit mix

Although not as key as other factors, your credit mix—how many different types of credit you've managed—can still have a noticeable impact on your scores. Adding an installment loan could improve your credit mix if you only have credit card debt on your credit history. Credit mix is 10% of your FICO Score.

Ways Debt Consolidation Could Hurt Your Credit

Not every part of a new consolidation loan is going to help your score. There are a few ways it could hurt your score, too.

Hard credit inquiries

Your lender performs a hard credit check when you apply for a new loan. Hard inquiries show up on your credit reports and could impact your scores for up to a year. The impact from a hard inquiry could be anywhere from zero to 10 or more points, depending on your credit profile.

The damage from hard inquiries generally gets worse the more inquiries you have. You could minimize that kind of damage if you use prequalification to check your rates with multiple lenders before committing to a full application. Prequalification involves a soft inquiry that doesn't impact your credit scores at all.

Average account age

Another important credit score metric is your average account age, which looks at how long you've had your credit accounts. Older is better.

Every new account drops your average account age. Since the length of your credit history is 15% of your FICO Score, your score might drop when you open a new consolidation loan.

Risk of adding more debt

While not a guaranteed result of a consolidation loan, another big credit score risk is that once your credit card balances drop to zero, you might rack up debt again. Prevent this by committing to new spending habits and adopting a realistic budget going forward. Consolidation could help you regain control of your finances—don't let it go again.

Ways you might stay on track:

• Keep your credit cards in a drawer where you won't be tempted to use them

• Switch to using cash when possible

• Remove credit cards from shopping apps so they're harder to use

If possible, it's generally better to leave at least one credit card open and in use; set it to pay a small monthly expense, like a subscription service. Then, set up autopay so your credit card balance is paid in full and on-time each month automatically.

That said, avoiding taking on new high-interest credit card debt is more important than keeping a credit card account on your credit profile. If you're too tempted to use your cards, it's probably better to cancel them all than to risk winding up back in debt.

Factors That Influence Whether Consolidation Helps or Hurts

Your existing credit profile and financial situation will decide a lot of how a consolidation loan impacts your credit scores overall. If you have no existing hard inquiries and have a well-established credit history, then a new consolidation loan could have minimal negative impacts to your score.

Your financial habits also make a lot of difference. Positive habits, like paying all of your bills on time and in full, typically boost your score. Only opening new credit when you need it is also a good habit to maintain. And good habits improve your financial health, regardless of your credit score. 

Closing your accounts after consolidating could be worthwhile if it might fix a spending problem. An account closed in good standing remains on your credit report for up to 10 years, giving your other accounts time to age and pick up the slack before it drops off your report. 

Keep in mind that closing credit cards could make your credit utilization go up if you don't also pay off your balances because your total credit limit drops. But if you consolidate all of that credit card debt first, those impacts could be avoided.

Tip: Utilization is a short-term metric that’s only worth optimizing if you’re applying for a new credit line (or apartment). Paying off your balances could see your utilization rebound as soon as the new balances are reported to the credit bureaus.

Alternatives to Debt Consolidation Loans

Consolidation isn't the only option you could have for managing your debts. Consider these alternatives if a consolidation loan doesn't feel like the right fit.

Balance transfer credit card

If you have good to great credit, you could qualify for a balance transfer credit card with a promotional 0% APR offer. You'll likely pay a balance transfer fee—usually 3% to 5% of the transferred balance—but the overall savings could still be huge. 

The math may check out—but only if you can pay off the card before the intro period expires. Once the intro period expires, any remaining debt will start accruing interest at the standard APR, which will likely be in the 20%-plus range.

Until then, you have time to pay off your debt at a 0% interest rate. It works best if you avoid spending on your credit cards so you don't rack up more debt while you're paying off your transfer.

DIY debt payoff strategy

If you can afford your monthly payments—plus a little extra—you may just need the right strategy to pay off your debts. Consider these popular DIY debt payoff methods. 

• Debt snowball. This method requires making all of your minimum payments, then focusing any extra money on the debt with the smallest balance. You could pay it off quickly, getting a good boost of motivation. Then, you move to the next-smallest balance—and so on.

• Debt avalanche. This method also requires making your minimum payments. However, you then focus on paying off the debt with the highest interest rate first. Then, you move on to the next-highest, and so on. While it could take longer to get your first win, you'll save more money on interest fees overall.

While these strategies won't consolidate your payments into one, or reduce what you owe, it could give you the direction you need to build an actionable plan.

Debt management plans

When you can afford your payments but need some guidance, consider credit counseling and a debt management plan (DMP). If you qualify, a credit counselor at a nonprofit credit counseling agency enrolls you in a DMP program that consolidates payments and lowers interest rates.

You don't take on a new loan, however. Instead, you make a single monthly payment to the credit counselor, who then pays your creditors. You generally repay your debt over three to five years. There's typically a monthly fee, and you'll probably need to close your credit card accounts.

Debt settlement

If you're struggling to pay your debts due to financial hardship, debt settlement may be an option. Settlement means a creditor agrees to accept a lower amount as payment in full and forgive the rest of your debt. 

You can DIY settlement negotiation, or hire a debt settlement company to negotiate with creditors on your behalf. In a debt settlement program, you make one monthly contribution to a credit settlement fund you control. If the company negotiates a settlement and you agree to it, you usually pay a lump sum from your account to close out the debt, and pay the company for negotiating the settlement. Debt settlement can have tax implications, so consult a tax professional if you go this route. 

Bankruptcy

Bankruptcy is a legal strategy that may help you reset your finances. There are two main versions, Chapter 7 and Chapter 13. 

Chapter 7 may be an option if you’re below a certain income amount and have a lot of unsecured debt. With this kind of bankruptcy, the court may take and sell some of your assets to pay as much of your debts as possible. The rest of your unsecured debt is generally forgiven. Debt forgiven in bankruptcy isn't usually taxed as income.

Chapter 13 bankruptcy could be an option if you don't qualify for Chapter 7 or you have assets you want to keep. It involves a three- to five-year repayment plan that restructures your debts. It could be useful if you're facing foreclosure and want to try and save your home.

Choosing the Right Debt Strategy for Your Situation

The right debt payoff strategy depends on your situation. It’s sometimes a good idea to consolidate by transferring debt to a balance transfer credit card or taking out a personal loan. 

In other cases, a DMP could be just the thing. And if you're overwhelmed by debt and facing financial hardship, debt settlement or bankruptcy could be the path forward.

Not sure where to start? Freedom Debt Relief offers a free debt evaluation that could help you decide the best way to take control of your debt.