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How to Consolidate Credit Card Debt Without Hurting Your Credit

In Money Management
A woman looks at her credit card bills online and worries about how to consolidate credit card debt without hurting her credit.

How to Consolidate Credit Card Debt Without Hurting Your Credit

Debt consolidation aims to turn out-of-control bills into lower-rate borrowing that you pay off over time. Unfortunately, it can often affect the very thing you are trying to protect: your credit score.

Below we consider some popular debt consolidation methods and how these may affect your creditworthiness. We explain where debt consolidation can risk causing more problems than it solves, and where some short-term credit score pain is a price worth paying for longer-term financial security. Read on to learn more.

What’s the Score? Debt Consolidation and Your Credit

If you’re struggling to pay off a personal loan or store credit or juggling balances on two or more credit cards, debt consolidation can offer a way to get your money woes under control before they do lasting damage to your financial prospects.

While it involves some tough choices, effective debt consolidation—combined with a budget and a commitment to reduce your spending—is a proven route out of unsustainable borrowing. By taking control of your debt, you’ll be able to begin saving and planning for long-term financial goals.

That said, changing your borrowing habits can affect your credit score, especially in the short term. Let’s take a closer look at how this works and when the pain of a short-term drop in your credit score might be worth it in the long run.

Personal Loans

Personal loans are the most popular way to consolidate debt, allowing you to turn short-term, variable-rate borrowing on store accounts or credit cards into a single, predictable monthly bill.

While you will most likely have a slightly lower interest rate, you’ll be paying off your loan for a longer period. That means you will end up paying more in interest over time, but you will also free up money every month that you can save or spend on longer-term goals.

Balance Transfer Credit Cards

Transferring balances on several credit cards to a single, lower-interest card is a good way to reduce your interest charges and overall credit card bill while avoiding late fees and making your payments easier to track.

Many cards also offer you an interest-free introductory period or pay you a bonus if you charge a certain amount to your new card within a certain time frame. Used wisely, these perks can buy you time and give you a valuable interest-free window to get ahead on your bills.

A balance transfer card can be a good way to take control of credit card debt, provided you are confident in your ability to reign in your spending.

Home Equity Loans

If you hold a significant amount of unsecured high-interest debt including credit card bills, payday loans, or unpaid store accounts, then dipping into your home equity may allow you to turn out-of-control borrowing into more sustainable debt.

By taking out a home equity loan against the stake in your mortgage you have already paid down, and using this money to pay off shorter-term loans, you are effectively lowering the value of your home until you can pay off the equity loan.

That isn’t a problem—unless you choose to sell. However, it does mean you miss out on the equity you would have earned if you had not taken out a loan. And, should you not be able to make payments on your loan, you risk losing your biggest fixed asset — your home itself.

Practically speaking, the biggest obstacle to using your home equity to consolidate debt is the significant costs involved in taking out a home loan which include origination, conveyancing and appraisal fees, and closing costs.

Retirement Account Loans

For people juggling short-term, high-interest debt, tapping into your accumulating retirement funds can be a tempting way to make month-end worries go away. Most 401(k) plans allow you to borrow up to $50,000 a year from your balance, and pay it off within five years.

This money can also be accessed almost instantly, with no credit checks or fees required. However, not only does the money need to be repaid, but you will not be able to make contributions to your retirement account until the debt is cleared. 

You’ll also earn less interest because your savings nest egg will be smaller, and you will miss out on any matching contributions from your employer. Worst of all, if you lose or quit your job, the entire balance of your loan will need to be paid off immediately.

Focusing on What Matters

Whatever method you choose to do debt consolidation, you are typically opting to exchange short-term, high-interest debt for longer-term borrowing paid at a somewhat lower rate.

While you should save on fees and late charges and you will pay less in interest charges every month, you will likely pay more in interest over the life of your loan or to your lower-interest credit card than you would have had you been able to pay off your original debts on time.

Conversely, by paying less each month, you start to free up valuable financial resources that would themselves have gone to servicing your high-interest debt.

Credit Where It’s Due

Debt consolidation offers the same mix of pros and cons when it comes to your credit score. It’s important to keep your larger goal of long-term financial stability in mind when assessing this. It also helps to understand which factors weigh most heavily on your credit score over time.

Short-Term Pain

For example, the process of shopping for and taking out a new loan or credit card may temporarily lower your score due to one or more hard pulls on your credit history. 

Taking out a fixed-term personal loan may also increase your debt-to-income (DTI) ratio, while closing accounts may reduce your credit mix and shorten your total credit history, both also likely to result in temporary drops in your credit score.

While this can be discouraging at a time when you are working hard to do better, try to remember that credit checks, credit mix, and even your DTI ratio have a relatively small and short-term effect on your actual credit score.

Long-Term Gain

Simply making payments on time alone makes up more than a third of your credit score, while missed payments can affect your score for up to seven years.

If you’re making a regular, on-time monthly payment on your new loan or credit card rather than missing or delaying payments on out-of-control debts, you should see a lasting improvement in your credit score very soon. 

You’ll also get a small boost from opening up a new credit account and, over time, your improved DTI ratio and lengthening credit history will lead to a long-term, sustainable improvement in your score.

Minimizing the Impact of Debt Consolidation

There are things you can do to minimize the impact of debt consolidation on your credit score, but these should always be seen against the larger goal of eliminating your debt and improving your ability to borrow money in the future. 

Here are some ways to minimize the impact of debt consolidation on your credit score:

  1. Shop for new loans or credit cards within a two-week window. All credit inquiries made within this period count as a single pull on your credit report.
  2. Keep old cards open after you pay them off. While you may have to make small purchases or pay an annual fee, this helps to maintain the length of your credit history and preserve your credit mix.
  3. Make payments on time. This way you won’t be penalized for missed payments and you will steadily improve your DTI ratio.

Figuring out which type of debt consolidation is best for your credit score is more complicated. For example:

  • Tapping into a 401(k) account for cash has absolutely no impact on your credit score, but comes with some serious long-term downsides that could ultimately affect your creditworthiness.
  • Opening a balance transfer card with a higher limit could immediately improve your credit utilization score, but the effect will be temporary if you keep spending.
  • Taking out a personal or home equity loan may affect your DTI ratio even after you pay off your other loans, but the effect of making payments on time and lowering your total debt will outweigh this in time.

Ultimately, debt consolidation is about taking the long view of your financial future and focusing on what really matters—paying off your debts in a timely manner. 

1st Advantage: Financial Tools for a Better Future

If you’re serious about taking control of your finances, Ist Advantage Federal Credit Union has the tools you need to get ahead including personal loans, home equity loans, and a range of high-quality credit cards. 

Our 1st Advantage Standard Mastercard makes it easier to manage your money better, with no charge to transfer existing balances to your new card. It also offers:

Click below to find out more about our credit card offerings and contact us today to learn more about how 1st Advantage FCU can help you take control of your finances.

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