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Debt Consolidation and My Credit Score: Friends or Enemies?

If you're planning on consolidating your debt, then it's a good idea to know how it will affect your credit score.

Photo by Justin Little
Photo by Justin Little

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Although they might seem to exist in different realms of the financial world, credit scores and debt consolidation have more in common than you might first think. If you’re considering debt consolidation or simply want to learn more about the process, read on to find out how the two work together and against each other, if using debt consolidation can affect your credit score, the risks involved, and whether it’s an option for those with lower credit scores.

While the ultimate goal of debt consolidation is to improve your financial position and reduce your debt, there are some occasions when using debt consolidation could hurt your credit score. Every time you apply for credit and a lender checks your credit history, a hard credit enquiry is recorded on your credit report. While this may not necessarily impact your credit score if you’re sparing with your applications, applying for several different credit products over a short period of time could see your credit score take a tumble. If you’re shopping around for the best debt consolidation loan, you may notice your credit score fall temporarily as you submit your applications.

If you aren’t realistic about what you can and can’t afford when you consolidate your debts, you could potentially leave yourself in a worse financial position than before. Defaulting on your repayments could lower your credit score over time.

Consolidating your debts can have many benefits, including making it easier for you to manage your repayments and reducing the amount of interest that you pay each month, but it can also have some positive effects on your credit score. In the long term, if you continue to make your repayments on time, your credit score may start to improve, slowly rising as you meet your financial obligations month after month. The process of reducing your total debt will see your total credit utilisation ratio lower, which will also positively affect your credit score.

Choosing to consolidate your debts can be largely positive, making it easier to manage your monthly repayments and allowing you to enjoy the benefits that come with more competitive interest rates. While many positive outcomes can come from using debt consolidation to better manage your money, several risks also need to be taken into account.

Your credit score may be affected

Applying for several different debt consolidation products could see your credit score fall in the short term. If you’re trying to find the best option for your needs, you may choose to apply for a loan from several lenders, but every time you submit an application, the lender will conduct a hard credit enquiry which will be recorded on your credit report. Each time a hard credit enquiry is recorded, your credit score will dip slightly.

You might find history repeating itself

Once you’ve managed your current debts, it may be tempting to apply for more credit. If you aren’t careful, you could find yourself in a situation similar to before you consolidated your debts.

You may end up paying more

It’s important to also be aware that consolidating your debts into a new loan could see you paying more over time as the total loan term is extended. With a longer loan term, you may end up paying more interest than you would have with the original loan.

You’ll need to ensure you can afford your repayments

If you aren’t realistic about what you can and can’t afford when consolidating your debts, you could find yourself struggling to meet the repayments of your new loan. Before you agree to the terms set out by any lender, be sure to check that the monthly repayments will be affordable on your current income. Failing to meet your financial obligations could cause harm to your credit score and see you face additional fees and charges. If you don’t think you’ll be able to make a repayment on time, chat with your lender about the options available to you.

Your financial habits won’t magically change

As much as you may like it to, debt consolidation won’t change your financial habits. If you find yourself in financial trouble, it’s important to take stock of your spending, address any reliance you may have on credit and plan out how you’ll manage your finances moving forward.

The process of applying for a debt consolidation loan can impact your credit score, especially if you’re shopping around for the best loan terms available to you. If you do have a low credit score, it will take some time to improve it, but it’s not impossible to do. There are no quick fixes, but limiting the number of credit applications that you make, ensuring that you pay your bills on time and lowering your credit limit could work in your favour. As you start to get in the habit of managing your finances more responsibly, your credit score should start to improve. The process of improving your credit score does take time, so it’s important to be patient and keep your end goal of a healthier credit score in mind.

The process of debt consolidation as a whole won’t necessarily be recorded on your credit report, but the actions that you take to complete the process will likely be. As debt consolidation typically involves taking out a new loan or an alternative line of credit to combine your debts into one, the hard credit enquiries that lenders make will be recorded. In most cases, a hard credit enquiry will remain on your credit file for five years, but they do tend to have less weighting over your credit score as time goes on. The influence of credit enquiries may vary depending on the credit reporting agency, so it’s good to keep that in mind also.

Much like a regular loan, each lender will set their own criteria for who they will and won’t accept for a debt consolidation loan. While your credit score may be a factor that the lender considers, your income, payment history and employment status are all likely to be used to help them make a decision too.

If you have a bad credit score, it may be more difficult to find a lender who will assist you in consolidating your debts. While it may be harder, it is possible. A lower credit score, however, could affect which lenders agree to lend you money as well as some features of your loan. If you have a low credit score, you may experience:

  • Limited loan and lender options
  • Higher interest rates
  • Lower borrowing limits
  • Shorter loan terms

Lenders typically view borrowers with lower credit scores as being a riskier investment as their financial history indicates there is less of a chance that the amount they borrow will be repaid. As such, they may insist on higher interest rates, lower borrowing limits and shorter loan terms to increase their chances of recouping at least a portion of the amount owed by the borrower. This is why it is important to make sure your credit score is high. You can check your credit score for free at ClearScore.

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