Which Debt Consolidation Company Will Not Damage My Credit?
For many U.S. families, outstanding credit card balances are a real balancing act. With an average of three credit cards each, and average card debt of $4,427, many households wrestle with allocating a their monthly repayment budgets across multiple accounts. Cardholders who routinely carry balances, especially those who pay only the minimum amounts due on one or more accounts, may fork out hundreds or even thousands of dollars each year in interest payments. Keeping up can feel like treading water, or struggling in quicksand. One possible source of relief is a debt-consolidation loan.
A debt consolidation loan is a personal loan you use to pay off all your outstanding credit card balances. It can simplify your budgeting by replacing separate credit bills with one monthly payment. Personal loans often have lower interest rates than credit cards as well, which can mean significant savings, especially if you pay the loans off quickly.
Debt consolidation isn’t a perfect one-size-fits-all solution, but it may be right for you. We’ll spell out the pros and cons so you can decide for yourself.
The benefits of debt consolidation are pretty straightforward: Using a single loan to pay off multiple credit card accounts leaves you with one monthly bill instead of a handful of statements. The payment amount is the same every month, which can simplify budgeting and eliminate the need for multiple checks or electronic payments.
In an ideal debt-consolidation scenario, you’ll pay a considerably lower interest rate on a personal loan than on your credit cards. Annual percentage rates (APRs) on typical credit cards range from 13% to 18%, but many exceed 20%. Personal bank loans carry fixed-rate APRs as low as 2.19% for borrowers with excellent credit, though APRs of 7-10% are more common.
A good place to start looking is your bank or credit union. You’re not likely to find “debt consolidation loan” on their menu of products, because debt-consolidation is just a special application of a personal loan—a lump-sum loan you agree to pay back in installments over a fixed number of months. Repayment periods can be as short as 2 years (24 months) and seldom exceed 7 years (84 months).
You can use a personal loan for any purpose you choose; for debt consolidation, add up the total balances on all your credit card accounts and apply for a loan in that amount.
As with any other type of credit, you’ll need to apply for the loan and meet the lender’s requirements to get it. They’ll likely check one or more of your credit scores, review your credit report and ask for some proof of income, such as a pay stub or tax return. They may want to know about your savings, as well. The lender will use this information to decide whether to issue you the loan, and to decide the interest rate they’ll charge you. If your credit scores are less than ideal, you could end up paying a high APR, or even getting turned down for the loan.
That creates something of a catch-22 if you have multiple credit card accounts at or close to their borrowing limits. You could really benefit from debt consolidation, but maxing out cards hurts your credit scores and makes it harder to get a loan. If you’re considering debt consolidation, try to look into it before your balances balloon.
When Shopping for Your Debt-Consolidation Loan, Keep the Following Guidelines in Mind:
To get the best borrowing terms possible, apply to multiple lenders. Besides your own financial institution, try other banks and credit unions. Specialized personal finance lenders are also an option, especially if your credit scores are less than ideal, but they tend to charge higher interest rates.
Pay attention to the total lifetime cost of the loan. Ask your lender to help you compare the total amount of interest you’ll be charged over the repayment term. Even at a considerably lower APR than credit cards typically charge, the cost over five or seven years could be a lot more than you’d expect if you just paid off the card in shorter order.
Expect an origination fee. You’ll typically be charged about 5% of the loan amount, which you’ll need to pay up front upon approval of the loan. The amount of the fee, like the APR and repayment duration is variable and somewhat negotiable, but expect trade-offs: if you negotiate a lower fee, you’ll likely see a higher APR or a longer repayment period.
Beware prepayment penalties. A great way to reduce the total cost of your loan is to pay it off in full ahead of schedule. Some loan terms discourage this by imposing fees that must be paid if you complete your payments early. Ask the lender about such penalties and avoid loans that include them.
If you qualify for a loan, the debt-consolidation process is simple: you’ll receive a check or a direct electronic funds transfer in the full amount of the loan. Once you receive it—and before you’re tempted to use it for anything else—pay off your outstanding balances in full.
Once you’ve done so, these steps can help ensure a return to firmer financial footing:
Take a long, loving look at your credit cards—and then put them away. You can keep one around for emergencies of course, but a successful debt consolidation strategy requires paying down your personal loan without racking up lots of new credit-card debt.
If you must make an emergency credit-card purchase, choose your card with the lowest APR. Safeguard your credit scores by keeping the purchase level below 30% of the card’s borrowing limit and pay off the balance as quickly as possible.
Don’t cancel your cards unless you really can’t resist using them, because your credit scores will drop as your total amount of available credit decreases.
To keep your credit scores in tip-top shape, assign a small, fixed monthly charge to each card before you tuck it out of sight: your Netflix account or gym subscription, for example. Then set up recurring electronic payments from your checking account to pay those cards off automatically each month. Keeping the accounts active while you pay off your personal loan can actually lead to an increase in your credit scores.
Take advantage of the early-payment option. Try making 13 monthly payments each year, four payments each quarter, and/or using your tax returns to make annual “bonus” payments on the loan. Each payment you shave off the repayment period means significant savings.
Make payments on time. Late or missed payments can take a major toll on your credit scores, so make sure you settle on a payment amount you can cover reliably month-in and month-out.
Try reducing the amount of the loan. Consider removing the sum of one of your accounts—either the one with the lowest APR, or the one for which you the balance represents the smallest percentage of the spending limit. You’ll still have to manage payments on the excluded account, but if you qualify for a lower loan amount, you could still end up with more financial breathing room.
Consider a debt management program. This is a different form of debt consolidation that you should treat as a last resort, if you cannot get a personal loan, and you’re unable to keep up with your monthly card payments.
Provided through a debt-management company or agency rather than a lender, a debt-management program (DMP) combines all your account payments into a single monthly bill, with a set repayment period. But it also requires you to close all the card accounts, under terms the debt-management company negotiates with the card issuers.
Participation in a DMP is noted on your credit files at the three major credit bureaus (Experian, Equifax and TransUnion), and lenders generally will not issue you a loan until you complete the program. Your credit scores will likely drop as well, with the loss of available credit from the account closures.
When looking for debt-management programs, beware of shady operators that seek high up-front fees. Look for non-profit organizations that insist on combining their services with credit counseling—consultation and educational services to help you manage your finances better in the future. A good reference for reputable debt-management programs in your area is the Financial Counseling Association of America (FCAA).
Combining your credit card bills through debt consolidation can be a great way to simplify your financial life. It can help you recover if your credit card spending gets overextended, and if you manage it right, it can even boost your credit scores over the long run.
Does Debt Consolidation Help or Hurt Your Credit Score?
When high interest rate debt like credit cards and personal loans take hold of your financial life, it can be difficult to manage multiple payments and accruing interest each month. Through debt consolidation, you have the opportunity to combine multiple debts into a single, fixed loan that carried predictable monthly payments and often a lower interest rate than credit cards. While a debt consolidation loan is helpful in terms of money management from month to month, many wonder if there is an impact on their credit score in the process. Here’s how debt consolidation affects credit in both the short and long term.
All lenders offering personal loans as a means to consolidate high interest rate debt require an application from potential borrowers. Part of the application process includes a credit check which results in a hard inquiry line item on a credit report. Although hard inquiries have a minimal effect on a credit score calculation, a new entry may result in a slight dip in a score immediately after an application is submitted. If multiple loans are applied for at the same time, borrowers will most likely experience a drop in their credit score of a few points for each inquiry.
Once a debt consolidation loan is approved, a borrower’s credit may take another slight hit. Credit score calculations are based heavily on how much credit is available to an individual, how much of that available credit is used, and the length of time a credit account has been established. When a debt consolidation loan appears as a new credit account, a borrower’s credit score may drop because no payments have been made to reduce the balance owed.
The good news is that despite the potential reduction in a borrower’s credit score after a debt consolidation loan is funded, over time, a new loan helps the credit score calculation. As the principal balance is paid off over time, credit score algorithms take into account the reduced loan amount owed compared to the amount initially borrowed. Additionally, making on-time payments – a significant component in the credit score calculation – creates a track record of good financial behavior that boosts a credit score exponentially. Using a debt consolidation loan to pay off other revolving credit accounts also improves one’s credit score over time, as this frees up some available credit for future use. So long as a borrower is responsible with the repayment of a debt consolidation loan, all signs point to improvement of his or her credit score as the loan is paid down.
Taking out a new personal loan is the most common method to accomplish debt consolidation, but some borrowers may not qualify for a loan based on their past credit activities. When that is the case, debt settlement may be an option.
Unlike debt consolidation, debt settlement is the process of negotiating with creditors to reduce the amount owed on credit card or other debts. The debt settlement company collects a fee for helping a borrower with this service, and a monthly payment plan is created to help pay down the negotiated balance for each creditor. While debt settlement can be a viable option for those who cannot get a debt consolidation loan easily, this alternative may have a negative impact on one’s credit score. Instead of showing debts being zeroed out with the help of a new loan, debt settlement appears as a note on each creditor entry in a credit report, which may be viewed as a negative to new lenders in the future.
Getting access to credit cards and other high interest rate debt is relatively easy; getting out from under the weight of that debt is not always a simple task. Consider your options for a debt consolidation loan carefully, and be sure to create a plan for repayment before accepting a new loan. When a debt consolidation loan is not an option due to bad credit or tight cash flow each month, debt settlement may be the next step. No matter the option you choose, take the time to understand the implications to your credit both now and in the future.