Understanding Risks and Problems First
Hard Inquiries Affect Your Credit Report
When you apply for a new credit account to consolidate debts, the lender will perform a credit check, resulting in a hard inquiry on your credit report. Each hard inquiry can temporarily affect your credit score by five points because lenders view new credit applications as a risk factor. To avoid significant impact, only apply for loans or credit cards that you can be approved for. Don’t frequently submit new applications and rely on luck for approval. Multiple hard inquiries generated by a credit card or personal loan application in a short period will definitely affect your credit. Although these inquiries will only impact your credit score for a year, the records will remain on your credit history for two years, which can be a red flag for future lenders.
New Accounts Lower Your Average Credit Age
Opening a new credit card or obtaining a loan to consolidate debts will decrease the average age of all your credit accounts, which may also temporarily reduce your credit score. The length of your credit history makes up 15% of your credit score and particularly considers the age of your newest account. A new account does not have a positive credit history yet, so your score will benefit from timely payments and the aging of the account.
Accumulating More Debt After Consolidation Increases Utilization Ratio
One of the biggest risks associated with consolidation is accumulating new debts before paying off your old balance. If you give in to the temptation to spend on a recently paid-off credit card, any improvements to your credit score will quickly disappear. The reason is that when you consolidate your debts into a new account to pay off other cards, your total available credit increases, thus reducing your credit utilization ratio. The lower this ratio, the better your credit score (which makes up 30% of your score). However, if you don’t leave these credit limits alone on your old cards, you will find yourself in trouble again. Here’s an example of how credit utilization can increase and affect your score:
| Card and Credit Limit | Balance After Debt Consolidation | Balance After Debt Consolidation + New Debt |
|---|---|---|
| Card #1: Limit $2000 | $0 | $500 |
| Card #2: Limit $3000 | $0 | $1200 |
| Card #3: Limit $5000 | $0 | $2000 |
| Card #4: Limit $15000 (Balance Transfer Card Used for Consolidation) | $7000 | $7000 |
| Credit Utilization Ratio | 28% | 43% |
Discipline your spending habits, or you will find yourself dealing with multiple debts again, including one large consolidated debt account. This may soon strain your budget and lead to delayed payments, or worse – defaults.
Closing Old Credit Cards Reduces Available Credit
If you felt a panic from the previous warning, don’t go too far in cutting your spending. That is, do not close those old credit cards that have no balances. This move will actually affect your credit score as well. By keeping the cards open and paid off, you will reduce your important credit utilization ratio just discussed, positively impacting your credit score while paying down consolidated debts. Close the cards and your credit score will be affected.
| Card | Credit Limit | Balance After Debt Consolidation | Balance After Debt Consolidation + Card Closure |
|---|---|---|---|
| Card Number 1: Limit $2000 | $0 | Not Available | |
| Card Number 2: Limit $3000 | $0 | Not Available | |
| Card Number 3: Limit $5000 | $0 | Not Available | |
| Card Number 4: Limit $15000 (Balance Transfer Card Used for Consolidation) | $7000 | $7000 | |
| Credit Utilization Ratio | 28% | 47% |
See how those empty cards can work in your favor while paying off the balance transfer card? So instead of closing unused cards, store them away while paying off the consolidated debt balance. If you’re at risk of a breakdown, lock the physical cards in a safe place, or freeze the cards in water. Make sure to remove all automatic payments from those cards and clear any saved card details from online shopping accounts to eliminate further temptation.
Late or Missed Payments Affect Credit History
It is absolutely crucial to make all your debt consolidation payments on time every month until the balance is paid off. Payment history significantly impacts your credit score, and records of late payments will damage it. If you ignore the debt consolidation balance and stop making any payments at all, your account will become overdue and the lender will send it to collections. Collection records remain on your credit report for seven years, and until that time passes, your credit score will suffer significantly. If you suddenly face financial difficulties and are worried you’ll miss a payment on your consolidated debt, contact your credit card or loan lender before the payment is late and your credit score is affected. There may be financial hardship options available.
Conclusion
If you make regular, on-time payments and do not incur any new debt, consolidating your existing debt into one account with a low interest rate, whether it’s a balance transfer credit card or a loan, can make the burden more manageable and reduce your credit utilization ratio. Any short-term negative impacts on your credit score will fade over time. Smart credit use in the future will enhance your credit score in the long run – and help you avoid another situation where you need to consolidate your debt.
Source: https://www.thebalancemoney.com/5-ways-debt-consolidation-can-hurt-credit-4693582
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