Debt Consolidation and Your Credit Score: How It Hurts and How It Helps

Americans hold a lot of consumer debt -- about $4.6 trillion, of which $1.1 trillion is credit card debt, according to the latest numbers from the Federal Reserve. The bad news for those debt holders is that credit card rates are getting more expensive.

To address inflation, the Federal Reserve has been raising interest rates in 2022. Banks use the federal funds rate as a gauge to set their own prime rates, which in turn set your credit cards' variable annual percentage rates, or APRs -- that's the interest you pay on your credit card balance.

More Fed hikes in the future will mean even higher APRs on credit cards. With debt becoming more expensive throughout 2022, now might be the time to look into debt consolidation.

Here's what you need to know about debt consolidation, how it affects your credit score and whether it's the right strategy for you.

How debt consolidation works

Essentially, debt consolidation rolls several loans or outstanding credit card balances into one single monthly payment with the same interest rate. It simplifies the payment process and, hopefully, gets you a lower interest rate. 

There are a variety of ways to consolidate your debt, from working with a nonprofit credit counseling agency to transferring balances onto a 0% APR credit card or even taking out a personal loan. Each method can affect your credit score differently. 

Credit card balance transfer
Credit card companies will often entice new customers with cards offering a limited-time 0% annual percentage rate (APR) on balance transfers. The introductory rate on these balance transfer cards typically lasts anywhere from six to 21 months, allowing card users time to pay off their debt instead of just the interest. 

There's often a balance transfer fee involved -- usually 3% of the balance -- but it can be worth it if you have a significant balance on one or more cards. And some companies will waive the balance transfer fee as a perk of signing up. 

Ted Rossman, a senior industry analyst with Bankrate, says a 0% APR balance transfer is often the best way to tackle credit card debt. (Bankrate, like CNET, is owned by Red Ventures.) 

The key to successfully consolidating debt with a credit card, he adds, is to avoid putting more purchases on the new card and to make sure you finish paying off the balance before the introductory APR expires. If you don't, you'll be hit with a much higher rate for the remaining balance.

If you worry about being able to make all your payments on time, it's worth noting that some companies apply a penalty APR when you miss a payment. They may even end the promotional interest rate early, so it's important to read the fine print. 

Personal loan
If you've already fallen behind on payments and your credit is suffering, a personal loan may be the right solution. They typically have lower credit score requirements than balance transfer cards and are unsecured, meaning you don't have to provide collateral. However, some lenders may not allow you to pay off business expenses with a personal loan.

"If you get a personal loan with 6% or 7% interest and are given five years to pay it back, that can work a lot better" than constantly making minimum payments on a card, according to Rossman.
 
Granted, 7% is among the lending industry's best APRs, and usually requires excellent credit, but even a borrower with a "good" FICO score (between 690 and 719) can expect a personal loan APR of 13.5% to 15.5%. That's still lower than the 20.65% charged by the average credit card.

Debt consolidation loan
A debt consolidation loan is a personal loan in the amount of your existing debt. It may offer a lower interest rate than a personal loan, depending on your existing credit score. If you can't get approved for a card with a 0% introductory APR, or want to simplify your monthly payments and reduce your interest payments, a debt consolidation loan could be a good option for you.

If you're approved, you pay off your existing debts right away then make regular payments on the loan, usually over several years. But as with other options, you have to show discipline: Using your newly available credit will just put you deeper in the hole.

"FICO has gotten wise to people taking out loans to pay off credit card debt and then running the cards right back up," said Rossman. 

There are also apps like Tally, which work similarly to debt consolidation loans by merging all your credit card bills into one payment. Instead of a bank or credit union, though, you're paying back Tally for the "loan," which is actually an open line of revolving credit.

Debt management plan
Another way to consolidate your debt is by working with a nonprofit credit-counseling agency, like Money Management International (MMI) or GreenPath, that will negotiate with creditors on your behalf.

Instead of paying lenders directly, with a debt management plan (DMP) you make a single payment each month to the agency, which then pays your creditors. There's typically a monthly fee involved -- at MMI, it's about $24. 

Thomas Nitzche, a certified financial educator with MMI, said a third of the people the organization counsels enroll in their debt management plans.

"Typically, those people are coming to us with an interest rate of about 28% on their cards," he said. "We can get it lowered to 6.4%, [so their payments] can actually go toward the principal."

The good news is that enrolling in a debt management plan doesn't directly affect your credit score. Accounts paid through a DMP may be flagged while you're in the program, but that's lifted after they're paid in full.

The bad news is that they usually require you to close the indebted accounts you enroll in the program, which can damage your credit.

But by making regular payments, Nitzche said, your credit score can ultimately increase by an average of 88 points.

Debt settlement companies
Debt settlement agencies are for-profit companies that also operate as intermediaries between consumers and creditors. But they're much riskier, Rossman said, because they typically advise you to stop making payments to your creditors as leverage to negotiate a lower amount.

"It can trash your credit score," Rossman told CNET. "The fact that your account has gone delinquent is a negative. And when you settle for less than you owe that's a negative, too."

How debt consolidation can hurt your credit score

All forms of debt consolidation affect your credit, though any hits are typically temporary and paying off debt will improve your score in the long run.

When considering whether to offer clients an introductory APR card or debt consolidation loan, lenders will run a hard credit check, or "hard pull," contacting one or more of the three credit reporting agencies: Equifax, Experian and TransUnion.

That credit check can lower your credit score by roughly 5 points and stays on your report for about one year. Multiple hard pulls in quick succession, however, can have a bigger negative impact on your score. (Some lenders may preapprove you for a debt consolidation loan or balance-transfer card with a "soft pull," which is similar to a background check and doesn't affect your credit score.)

If you're transferring balances to a 0% introductory APR card and then closing the existing cards, it can raise your credit utilization ratio -- the percentage of your total available credit being used -- and hurt your score.

Getting a loan or a new credit card will reduce the average age of your credit, which also lowers your score, especially if you close out your old credit cards. Length of credit history is about 15% of your credit score. The longer your active accounts have been open, the better. Too many new accounts, meanwhile, reflects poorly.

You can mitigate the credit hit of debt consolidation by keeping your old cards open, even after you've transferred the balance or paid it off. But don't be tempted to start racking up more charges on them, or you'll soon find yourself in the red again.

How debt consolidation can help your credit score 

Assuming you're able to meet the lender's terms, experts say debt consolidation should be a net positive on your credit in the long run.

"You may come close to maxing out that new card, which isn't great," Rossman said. "But what it does to your overall credit profile is good. You have to look to the medium or long-term for the real benefit." 

The most obvious way is by enabling you to make regular payments with a lower interest rate. Payment history makes up 35% of your credit score, according to Experian. 

And if you have only credit card debt, taking out a debt consolidation or personal loan can improve your credit mix -- the different types of debt that you hold -- which accounts for 10% of your credit score. 

A good credit mix demonstrates you can handle a variety of rotating credit (credit cards) and installment loans (mortgages, car loans, student loans, etc). But any benefit to a good credit mix is predicated on you making regular payments on your accounts. 

When should I think about consolidating my debt?

If you have a thousand dollars on two credit cards, and are paying off your balances each month, debt consolidation probably isn't worth it, Nitzche said.

You should be carrying at least $5,000 in unsecured debt before considering it, according to Rossman. 

To choose the right strategy, tally up your credit card balances and loans, factoring in the interest rates, minimum monthly payments and outstanding balances.

And be sure to compare interest rates, terms of the contract, penalties and other information from multiple lenders.

Other advice for consolidating debt

The most important thing, Nitzche advises, is communicating with your creditors. Don't wait until your accounts have fallen into collections, which will make it much harder to negotiate a plan.

"Especially during the pandemic, lenders were hanging out shingles that they were willing to work with consumers," he said. "You need to do whatever you can do to get the interest rate down."