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Debt-consolidation isn’t a magic fix for bad credit. But it can potentially help you get back on track over time.
If you have several debts with high interest rates — credit card balances, for example — debt consolidation could allow you to take out one new loan, pay off your existing debts, and then repay the new loan in monthly installments.
When you consolidate debt, it’s key to look for loan terms that are more favorable than the terms you have on your existing debts — paying less interest helps make it possible to pay down your debt faster. Consolidating can also allow you to reduce multiple monthly debt payments to just one, which can reduce your chances of making costly mistakes like missing payments.
And although taking out a loan can temporarily ding your credit scores, debt consolidation could help you improve your credit over time if you consistently make on-time payments and lower your credit utilization ratio (the amount of available credit you use at any given time).
What makes bad credit happen?
Credit reports are snapshots of how you’ve managed credit in the past and how well you’re doing right now. Lenders use reports to help them make decisions about who they’ll lend to and what terms they’ll offer. And they use credit scores as another way to measure how well you’ve managed the money you borrowed in the past and to predict how likely you are to repay new credit.
Here are several factors that can have a negative effect on your credit scores.
- Missed or late payments
- Using most or all of your available credit
- Having experience with just one type of credit, instead of a mix
- Having a short credit history (or none)
- Having multiple recent hard credit inquiries on your credit file
How debt consolidation could affect credit
If you’re struggling with multiple high-interest debts and large monthly payments, you may be considering debt consolidation as a solution. Building credit could be one possible outcome of consolidating debt, but there’s a lot to consider before you commit to a debt-consolidation loan.
Let’s look at how debt consolidation might affect your credit.
Your credit scores may drop slightly at first
This could happen for two reasons. First, when you apply for new credit, the lender typically conducts a hard inquiry into your credit history. This will show up on your credit reports and may temporarily lower your scores.
If you’re approved for a new loan, that account will reduce the average length of the accounts in your credit history — which can have a small but negative effect on your credit. But as the account matures, this part of your credit should improve.
The good news is that making on-time payments on the loan could help improve your credit, so be sure to make your payment on time every month.
Long-term improvement is possible
A debt-consolidation loan could help improve your credit if you make the right moves.
Look for a loan with a lower annual percentage rate, or APR, than you’re paying on your existing balances. If you qualify for a debt-consolidation loan with a lower rate, more of your payments will go toward paying down your debt, which could make it easier to pay off more quickly. Paying down your debts can also reduce your credit utilization ratio, which can help improve your credit scores.
Paying at least the minimum amount due on the loan on time every month can also help build your credit. A debt-consolidation loan could reduce the number of debt payments you have to make in a month, which may make it easier to make payments on time because you’ll have fewer to keep track of. If you have room in your budget, try to pay more than the minimum every month — this could help you pay down your debt sooner and pay less in interest.Learn more: Debt consolidation with a personal loan
What to consider before consolidating debt
It may be possible to get a loan with bad credit. But to help improve your credit through debt consolidation, look for lower interest rates than what you’re currently paying and make sure you’ll be able to make the payments.Personal loan with bad credit: Proceed with caution
Can you get a good interest rate?
Consolidating your debt makes financial sense only if you’re able to get a lower interest rate than you’re paying on your existing debt. But keep in mind that the best rates are typically offered to people with good to excellent credit. If you have poor credit, you could end up with a high interest rate, or you might not qualify for the loan amount you need.
You may be able to find lower interest rates or personal loan options with more flexible credit requirements at credit unions or online lenders. And some lenders will allow you to apply for prequalification to get an idea of what kind of rates you might qualify for, which shouldn’t hurt your credit scores.
Will you create more debt?
You might hope that debt consolidation will help you get out of debt. But in order for that to work, you’ll need to change behaviors that helped land you in debt in the first place. For example, you might need to evaluate your spending habits, start budgeting or stop using credit cards for a while.
Also, pay attention to the loan term. If it’s long, you might end up paying more in interest over time, which is costlier to you.Credit Karma Guide to Budgeting
Can you afford the payments?
Before taking out a debt-consolidation loan, go over your budget and figure out how much you can afford to put toward your debt every month.
If you’ve already taken out a loan but can’t swing the payments, you may want to consider credit counseling. A credit counselor can go over debt-management plans, help you build a budget or help you contact your creditors to work out a repayment plan.
Debt-consolidation loans have the potential to help you improve your credit — but you’ll have to work at it.
Comparison shop for the lowest interest rate you can qualify for, since paying less interest and more principal could help you repay your debt faster. Address any spending habits that may have helped to land you in debt in the first place. Always make your payments on time every month, and avoid adding new debt on any credit cards you pay off with your debt-consolidation loan.
Although debt consolidation may ding your credit temporarily, overall it can help you improve your credit if you consistently make on-time payments and reduce your overall credit utilization ratio.