Q&A: Will a consolidation loan hurt my score?
Seeking a loan or balance transfer will have limited impact on your score
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Dear Credit Guy,
Will a debt consolidation loan hurt my credit? If so, what is the average dip?
My credit score is 650, all payments made on time and in good standing. My credit score is low due to high credit card debt-to-income ratio.
I have a mortgage in good standing, but am looking to refinance in six months to a year. – Chad
Because you want to refinance your mortgage within the next year, you are wise to take steps to get your credit in its best possible shape as soon as possible.
Paying off your credit card debt with a debt consolidation loan might be an option for you, especially if you have a large amount of debt spread across many accounts on which you are paying high interest rates.
You certainly need to find a way to reduce your credit utilization – the amount you have borrowed compared to your credit limits – as this is the second most important factor in credit scoring calculations. The most important factor in credit scoring, of course, is making on-time payments.
However, you do need to know that applying for a debt consolidation loan will trigger a hard inquiry to your credit report. This could bring your credit score down a few more points in the short term.
It is difficult to say exactly how much, but there are things you can do to mitigate the damage.
What would-be lenders pay attention to
Inquiries and new accounts are two areas that would-be lenders are interested in because those tend to signal certain things.
- Too many inquiries in a short period of time – unless it’s for something like a mortgage or a car loan – can be seen by lenders as risky.
- Too many new accounts also can be seen as a sign of credit problems.
Since you are presumably talking only about one new inquiry for a consolidation loan, I don’t think you have too much cause to worry about your credit score. Hard inquiries usually ding about five points off your score and drop off of your report after two years.
If you can qualify for a consolidation loan that will both pay off your total credit card debt and reduce the overall interest you will pay, this could be a great solution.
If you're considering this pathway, however, here are a couple of things to keep in mind:
- Research all of your options before consolidating your debt. (More about that in a minute.)
- Acknowledge the root of the problem and make all necessary changes to avoid incurring debt again.
See "6 debt consolidation traps and how to avoid them" for further information and advice.
Another option: Balance transfer
Depending on your situation, you might also look at transferring your credit card balances to a zero-interest credit card.
This option can save you the most money as you won’t pay any interest for the duration of the 0-percent promotional period.
You will, however, have to consider a few things:
- Balance transfer fee: This is usually about 3 percent of the amount transferred.
- Hard inquiry: Applying for a balance transfer credit card also will generate a hard inquiry and a new account on your credit profile.
- Good credit required: Balance transfer offers generally require a very good credit score.
- You may not get a large enough credit line. As a result, you may not be able transfer all your card debts to this one card, which could leave you with some high-interest card debt remaining.
What you need to do before applying
With that in mind, whatever route you choose, you need to be fairly certain that you will qualify for the debt consolidation loan or balance transfer. This goes back to what I was saying about hard inquiries.
Video: What is a balance transfer credit card?
You seem to have a good handle on your credit score, but if you haven’t looked at your credit reports lately you should probably do that and check for any errors before you get started.
You are entitled to get three free copies of your credit report every year – one from each of all three major credit bureaus, Equifax, TransUnion and Experian – at AnnualCreditReport.com, or you can check your credit report and score for free anytime at CreditCards.com.
Once you have decided which avenue to take to pay off your credit card debt, you will need to consider how you will deal with your credit moving forward.
- Keep your credit cards open.
I would not suggest that you close your credit cards when you pay them off.
- Use your cards for everyday spending only.
Charge sparingly over the next few months, buying things you plan to use anyway – such as gas for your car or groceries for your household. These are items that you should build into your monthly spending plan so that when the bill arrives, you can pay the balance in full.
- Build your credit.
Charging only what you can pay off in full will demonstrate to would-be lenders that you are responsible with the credit you have been given.
As you work to build your credit up, remember that on-time payments are crucial. Pay your bills on time, every time. I wish you good luck.
Take care of your credit!
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