Debt consolidation merges multiple debts into one, mostly with a faster payoff and a lower interest rate. Some common options for consolidating debt are taking out a personal loan or getting a balance transfer card. Both of these require a hard inquiry that lowers your credit score.
However, keeping a check on your spending habits and making timely payments after consolidating your debt has an overall positive effect on your finances. Here’s how these debt consolidation approaches affect your credit:
Balance Transfer Card
Pros
– You can repay the loan early without having to pay any penalty.
– Lower interest rate (often for a fixed period), including a 0% APR for people with excellent credit scores.– Payments are flexible.
Cons
– Flexible payments are a part of an offer, and not clearing the debt before the offer ends can result in a higher interest rate.
– Your credit score lowers as your credit utilization (the amount of available credit in use) increases.
Personal Loan
Pros
– Managing your finances becomes easier, as several payments can be combined into one.
– The credit score required is generally lower than what you would need to get a balance transfer card.
– Transferring unsecured credit card bills to a personal loan can lower your credit utilization.
– As personal loans are installment loans, they can improve your credit mix if you’ve only ever had credit cards.
Cons
– Most personal loans have a prepayment penalty.
– You may have to pay high fees to take out the loan. Ensure you check the APR before finalizing the loan.
– Using newly available space on credit cards to take out a personal loan can lead to more debt.
– If you fail to make your payments on time, you’re liable to pay late fees that can damage your credit.
– Apart from these, other debt consolidation approaches include:
401(k) Loan
A 401(k) loan doesn’t affect your credit score as it’s excluded from your credit report.
Home Equity Loan or Line of Credit
Depending on which of these two you get, your credit report may categorize this as an installment loan or a revolving account. You’ll also have to undergo a credit check.
Remember, replacing your unsecured debt (like credit card debt) with secured debt (like an auto or home loan) isn’t a good idea because if you default on your payments, you could lose your vehicle or home.