How Debt Consolidation Affects Your Credit Score

by Michelle Vullo Pastor, MBA, Accredited Financial Counselor   

Many of my clients ask if debt consolidation will help their credit score. The answer is complex, and to explain why, I like to use an example of a young couple who came to me for financial counseling.

They explained that they were in a very stressful financial situation a year ago. They had $6,000 in credit card debt, could barely pay the minimums, and couldn't make ends meet much longer. Stressed from dealing with their finances, they decided to combine their credit card balances by taking out a debt consolidation loan to help their credit score and get their finances in order. They were excited to consolidate all their debt payments into one, and with a lower interest rate as a bonus, they jumped at the chance.

When I asked if their debt consolidation plan had worked, they told me what I had already assumed. It turns out that, in the past year, they ran their credit card balances back up and over the original debt of $6,000 to a new high of $14,000. On top of having to pay their credit cards, they still had to make monthly payments on their $6,000 debt consolidation loan. Their debt consolidation plan didn't work, and they were now drowning in debt because of it.

To understand how this couple's debt consolidation affected both their credit score and their overall financial situation, I'll analyze the situation step by step.

Initially, prior to consolidating their debt, this couple applied for credit, which lowered their credit scores. Every time they applied for credit, their credit score took a hit. They get two free inquiries per year, but after that, each one reduced their credit score between four and seven points.

After they took on the debt consolidation loan, they didn't close out their credit card accounts, which was a move that helped their credit score. A large part of their credit score is determined by their credit "utilization" rate, that is, how much of their available credit they are using. This rate should stay below 30%; the lower, the better.

As they took on a debt consolidation loan to pay off credit cards, they added another $6,000 to their overall credit limits. Prior to the debt consolidation loan, they had about a 43% utilization rate ($6,000 credit card balance divided by a $14,000 credit card limit), but after the debt consolidation loan, their utilization rate dropped to a much better level of 30% ($6,000 balance divided by a $20,000 limit). By keeping the lines of credit open, they reduced their utilization rate, which helped their credit score — at least temporarily.

Unfortunately, what was best for their credit score was not best for their financial situation. With their credit card accounts left open, they continued to rack up debt until they maxed out their credit cards once again. Their credit scores then took a huge hit because their utilization rate soared to 100%.

Their situation continued to spiral out of control as their minimum credit card payments went up and they couldn't make their credit card or debt consolidation loan payments on time. The late payments then led to numerous hits to their credit, as just one late payment can drop a credit score by 100 points.

All in all, this couple's credit score decreased with their debt consolidation loan, but it doesn't have to happen that way. Debt consolidation can be a great tool to help a credit score and to make a stressful financial situation better — if used correctly.

Consolidating debt works great when it is one step in a financial plan and not used just to move debts around. The financial plan also requires steps to deal with the issues that led to the credit card debt in the first place and to address increasing income and/or decreasing expenses to get spending in line with income. Debt consolidation, when used in conjunction with these vital pieces of the plan, will help your credit score and your financial situation.

Points to remember:

  • Debt consolidation can help your credit score when it reduces your utilization rate — but only if you keep the credit card accounts open and don't use them.
  • On the other hand, debt consolidation will hurt your credit score if you shop around for credit and get numerous inquiries, if you run up your credit card balances after you consolidate the debt, or if you're late on your loan payments.

To find out debt consolidation's effect on your credit score, click here to estimate your credit score with and without the consolidation loan.