If you have more debt than you can comfortably afford to repay, consolidating that debt into one loan may not have an immediate effect on your credit score. But while consolidating your debt can help you develop healthy financial habits, it may lead to an improvement in your credit score over time.
How do credit scores work?
Credit scores are generated by credit bureaus such as Equifax and Experian using information from your credit history. If you have a habit of borrowing money and paying it back on time, you are more likely to have a good credit score. But if you’ve missed loan payments or had defaults in your credit history, you’re more likely to have bad credit.
Banks, lenders and credit providers use credit scores when applying for loans to assess your risk as a borrower. Borrowers with good credit are more likely to be offered low interest rates, low fees, or additional features and benefits, while borrowers with bad credit may find it more difficult to successfully apply for a loan or may have to pay higher rates and fees.
How does debt consolidation work?
Debt consolidation consolidates all your unpaid debts into one new loan. This means that you will only have one repayment to manage, rather than several debts to pay off. You will also be charged interest only once, at the single interest rate, which may be lower than some of your other debts. It could save you money and help you pay off your debt a little easier.
There are a few potential options for consolidating debt, including:
- Redemption of personal credits: These can be secured by the value of another asset or left unsecured. You can be offered a fixed or variable interest rate, and the choice of a shorter or longer loan term – shorter loans mean higher repayments, but lower long-term interest, and longer loans long means cheaper repayments, but can cost more in total interest charges.
- Credit cards with balance transfer: These cards allow you to transfer outstanding balances from other credit cards and then pay little or no interest for a limited time. This can give you the opportunity to try to erase your debt without it growing. However, if you cannot repay the outstanding balance within the interest-free period, you will be charged interest on whatever remains, often at a high rate.
- Refinance your mortgage: If you already have a home loan, you may be able to use the equity in your property to borrow additional money when you refinance to consolidate other debts. This means that you will be able to benefit from the interest rate on your home loan, which is likely lower than many personal loans and credit cards, although the longer term of the loan may mean that you will pay more total interest.
How could debt consolidation improve your credit rating?
If you’re struggling to manage the repayments of multiple debts, a debt consolidation loan could be a first step in regaining control of your finances. With just one payment to budget for and one due date to remember, it can be easier to avoid missed payments and make steady progress toward wiping the slate clean.
If a record of regular and consistent repayments appears in your credit history, it can help gradually improve your credit score over time.
How could debt consolidation hurt your credit rating?
Consolidating your debts may not automatically improve your financial situation. Your consolidated debt might take longer to pay off, costing you more in total interest, and there might also be other fees and charges to consider. If you miss payments or fail to repay your consolidated loan, your credit score could be compromised.
Plus, consolidating your debts may not matter if you then go out and rack up new debt on loans and credit cards. To help limit the risk of starting the cycle of debt all over again and leaving you in the same or worse situation, you can consider canceling credit cards and other loans and credit accounts once you have consolidated your debts.
Consider contacting a financial advisor for more information on whether consolidating your debt may be the best choice for your financial situation. For example, a mortgage broker may be able to offer advice on refinancing options. And if you find yourself in financial difficulty, the National Debt Helpline may be able to provide financial advice.