How Does Debt Consolidation Work?

Debt consolidation involves using a loan or a credit card to pay off high-interest debt, typically one or more credit card balances. The goal is to secure a loan or credit card with a lower interest rate than what you’re currently paying, allowing you to save money and potentially become debt-free more quickly.

Common ways to consolidate debt include:

• Personal loans: These loans generally have lower interest rates than credit cards and offer repayment terms ranging from one to seven years. They are typically unsecured, meaning you don’t need collateral to get approved.
• Balance transfer credit cards: These specialized credit cards offer introductory 0% annual percentage rate (APR) promotions, which can range from 12 to 21 months. You can transfer a balance from another credit card and pay it down with no interest charges. However, there is usually an upfront balance transfer fee of 3% to 5% of the transferred amount.
• Home equity loan or line of credit: If you have significant equity in your home, you could use it as collateral to get a home equity loan or a home equity line of credit (HELOC). These loans have lower interest rates than personal loans but come with upfront and ongoing costs. Failure to repay the loan could result in foreclosure.

How Does Debt Consolidation Affect Your Credit?

Debt consolidation can impact your credit in several ways, both positively and negatively:

• Applying for a new loan or credit card: Lenders will typically run a hard inquiry on your credit reports, which can temporarily affect your credit score.
• Opening a new credit account: This reduces the average age of your credit accounts, impacting your length of credit history.
• Changing your credit utilization rate: Your credit utilization rate—the percentage of your credit card limit you’re using at a given time—is a significant factor in your FICO® Score. A balance transfer to a new credit card could result in a higher utilization rate on the new card, negatively impacting your credit score until you pay down the balance. Conversely, if the balance transfer results in a lower utilization rate across your credit cards or you use a loan to pay off your credit cards entirely, it could positively impact your score.
• Making payments: Missing a payment on your old accounts during the debt consolidation process or on the new loan or card after consolidation can significantly negatively impact your credit score. On the flip side, making on-time payments can help you establish a good credit score over time.

As you eliminate debt, you’ll free up more cash flow in your budget, making it easier to manage your expenses and avoid more debt in the future.

How to Minimize the Impact Debt Consolidation Has on Your Credit

While it’s impossible to consolidate debt without affecting your credit at all, there are ways to ensure that any negative impact is minimal—or at least temporary:

• Consider keeping old credit cards open: Transferring debt from one or more credit cards to a new one could result in a higher utilization rate on the new card. Keeping your old cards open can help maintain a low utilization rate across all your cards.
• Pay off a balance transfer quickly: Although you may have more than a year to pay off your debt with no interest, the faster you can pay down the balance, the quicker your credit utilization rate will come down to a level that’s better for your credit.
• Avoid applying for multiple loans or credit cards: Applying for a lot of credit in a short period can be a red flag for lenders and potentially damage your credit. Try to avoid taking out credit unless you need it. If you get denied for a loan or credit card, wait until you know the reasons and can work on improving your credit before applying for something else.
• Pay on time: Make it a priority to always pay your bills on time. If you miss a payment, pay it quickly—late payments don’t get reported to the credit bureaus until they’re 30 days past due.

Monitor Your Credit as You Work to Pay Off Debt

When consolidating debt, it’s crucial to understand how your actions impact your credit. With Experian’s free credit monitoring service, you can access your FICO® Score and Experian credit report, giving you valuable information as you pay down debt and improve your credit and overall finances.

If consolidating debt impacts your credit score, keep track of your progress as you work to rebuild it. Monitoring your credit can also make it easier to avoid mistakes that can damage your credit in the future.