Debt consolidation is designed to improve your finances and your credit score. One payment is easier to remember than several, and avoiding late payments is a critical part of building credit.
There are still ways that debt consolidation could hurt your credit.
When you apply for a new credit line to consolidate, the lender will place a hard inquiry on your credit record. This can hurt your credit. The impact of one hard inquiry is minor, but if you’ve added several other hard inquiries lately you could see a noticeable drop.
It’s ok to shop around for the best deal on a debt consolidation loan. Just keep all of your applications within a 15-day window. The credit bureaus will see that you are shopping and record only a single hard inquiry.
If you use a balance transfer card to consolidate debt, the combined balances you transfer could eat up a large percentage of your credit limit. Carrying a high credit utilization on even a single card can dent your credit.
The single greatest risk is that you won’t handle your debt consolidation loan well. Consolidation rearranges debt, it doesn’t make it go away. If you make late payments on your consolidation loan you will do real harm to your credit.
Avoid taking on new debt until your consolidation loan is paid off. Piling more high-interest debt onto your cards is a one-way road to trouble.
Other Things to Watch Out for With Debt Consolidation
Loans and balance transfer cards often have fees. Calculate all your costs – including loan or balance transfer fees – to make sure the deal is worth it!
If you fail to make on-time payments, you might actually be doing your credit more harm than good. The best way to reduce your debt without compromising your credit is to create a repayment plan and stick to it.
Don’t incur additional debt – especially credit card debt – until you pay off your consolidation loan. You will run the risk of overextending yourself and buying unable to make payments and you will lose any advantage you gained from consolidation.
How You Can Consolidate Your Debt
Debt Consolidation is a simple process. Consider your options for combining all your debts into one.
If your credit is reasonably good you can probably qualify for a personal loan on attractive terms. Some personal loans are marketed specifically as debt consolidation loans: the lender will pay the proceeds directly to your creditors.
Balance Transfer Cards
Most credit card issuers offer balance transfer cards with low-interest introductory periods. You transfer your other balances onto the card and pay it off before the introductory period expires, with no interest.
Watch out: many issuers cancel the zero-interest period if you make a late payment. If you don’t pay the new card off within the introductory period your interest will shoot back up.
Most balance transfer cards with good terms require good credit.
Home Equity Loans
A home equity loan lets you borrow against the equity in your home. Approval is relatively easy and interest rates are low. If you can’t pay off your loan, you could lose your home.
Retirement Account Loans
You can get a loan from your IRA or 401(k). There’s no interest (it’s your money) but you may sacrifice investment gains and you will have to meet the payment schedule or face tax consequences. . Simply make payments in accordance with the terms of the loan. Failure to pay means you may face tax penalties.
Tip: A loan from your retirement account can be a smart move when markets are stagnant or falling. Your money won’t be growing anyway!