How Debt Consolidation Affects My Credit Score

If you are managing multiple debts, you may have considered a debt consolidation loan or a Personal Loan to combine them into one easier payment. But before moving ahead, you are probably wondering: how does a debt consolidation affect my credit score? Let’s explore how this process works and what you to know.

What is a Debt Consolidation Loan 

A debt consolidation loan combines several debts like credit cards, personal loans, and medical bills into a single loan. This can:
•    Simplify your monthly payments
•    Potentially lower your interest rate
•    Help you pay off debt faster
Usually, people consolidate their debts using a Personal Loan or balance transfer. The goal is to save money on interest and reduce financial stress.

How Does Debt Consolidation Affect My Credit Score

Applying for a debt consolidation loan can impact your score in both positive and negative ways. Let’s explore them:

1.    Hard Inquiries May Lower Your Score
When you apply for a debt consolidation loan or Personal Loan, lenders create a hard inquiry on your credit report. This can temporarily reduce your credit score by a few points. A hard inquiry generally impacts your score for about one year and remains on your credit report for 2 years. However, the effect is usually minor (around 5-10 points).

2.    Credit Utilisation Ratio May Improve
Your credit utilisation ratio i.e. the amount of credit you are using compared to your total available credit, plays a crucial role in your credit score. For example, if your total credit limit is ₹10,000 and you are using ₹7,000, your utilisation is 70% - a high number that can hurt your score.
After consolidating debt with a Personal Loan, your credit balance drops to zero, reducing your credit utilisation ratio. Lower utilisation boosts your score.

3.    Credit Mix Can be Improved
Credit scoring models (like FICO and vantage score) look for a mix of credit types like credit cards, personal loans, and auto loans. By adding an instalment loan to pay off revolving debt, you diversify your credit mix. This can slightly boost your score, although it is a smaller factor (around 10% of your score).

4.    Positive Repayment History Can be Built
Your payment history is the biggest part of your credit score (about 35%). If you make on-time payments on your new debt consolidation loan, you can strengthen your payment history, which is the single most important thing you can do for your score. Missing payments, on the other hand, can significantly affect your score.

Immediate vs Long-Term Effects on Credit Score

Here’s how the impact typically unfolds:

•    Short-term Effects: Your score may dip slightly because of a hard inquiry or changes in your credit mix.
•    Long-term Effects: If you lower your credit utilisation and make, consistent, on-time payments, your score can increase over time.

When Does Debt Consolidation Make Sense

Debt consolidation can be a smart move if:
•    You have high-interest debts and can qualify for a low-interest rate loan
•    You want to streamline your payments and avoid late fees
•    You have a steady income to keep up with the new loan payments.

However, it is not a one-size-fits-all solution. If your debt is overwhelming and you cannot realistically make payments even with a consolidation loan, you might consider talking to a counsellor or exploring other options.

When Can Debt Consolidation Hurt Credit Score

While a debt consolidation loan can improve your score in the long run, there are a few mistakes to avoid:

1.    Closing Old Credit Card Accounts
After closing your debts, you may be tempted to close credit card accounts. But closing accounts reduce your total available credit and can increase your utilisation ratio, which can affect your credit score.

Unless a credit card has high fees or you are worried about overspending, keep old accounts open. This can help your score by keeping your available credit high and maintaining the length of your credit history.
2.    Taking on New Debt
Consolidation only works if you avoid building up new debt. If you take up new loans or credit after paying them off, you will end up in more debt and your credit score will suffer.

To Conclude

Debt consolidation can affect your credit score in different ways, some good and some not-so-good. Initially, you might see a small dip due to a hard inquiry. But overtime, paying off high-interest debt and lowering your credit utilisation can improve your credit score. The key is responsible repayment. If you are disciplined and avoid taking on new debt, consolidation can be a solution to regain control of your finances and build a healthier credit profile.

If you are considering consolidation, Poonawalla Fincorp offers Personal Loan for debt consolidation of up to ₹50 Lakh at competitive interest with minimal documents and quick approval. Apply now!

FAQs

1.    How long does debt consolidation stay on my credit report?
A debt consolidation loan is treated like any other instalment loan and will stay on your credit report for up to 10 years. Positive payment history can help your credit score, while late or missed payments can harm it.

2.    Can debt consolidation loan help me save money?
Yes, if you qualify for a lower interest rate than your existing debts. This can reduce the amount you pay in interest over time and potentially save you money.

3.    What happen if I miss payments on my consolidation loan?
Missing payments can significantly affect your credit score, just like any other loan. It may also lead to late fee and even default if you don’t catch up.

4.    Does consolidating debt affect my chances of getting a new credit in the future?
In the short term, your score might dip slightly because of the new loan. But if you handle your consolidation loan responsibly, it can improve your credit profile and make demonstrate you more reliable to the lenders in the future.