Will consolidation of debts affect your credit score?

Ailsa Adam August 25, 2023

When you owe a lot of money to be paid off to different lenders, you can think of consolidating your debts. This seems a smart decision, as you can stop accrued interest on the unpaid balance.

These loans have come a long way; the idea is to merge all your outstanding debts into one new personal loan. Since consolidation allows for merging outstanding debts, it does not mean that all types of loans are worth merging.

These loans are quite expensive, and they are not easy to secure. Lenders usually expect you to have a good credit rating to sign off on consolidation.

It means you should start applying for these loans as soon as you find it difficult to adhere to payment schedules. Once your credit score drops, lenders may refuse you. If not, they will charge a very high interest rate.

Why should you consolidate your debts?

Consolidating is a good strategy when you want to save money on interest. According to a report by LendingTree, the demand for personal loan inquiries for consolidation rose by 29.1% between the third quarter of 2021 and the same period of 2022.

Consolidation provides you with a way to escape a debt spiral when interest rates are very high. Your payments will be spread over, making managing the debt easier. When you have multiple loans to pay off on different due dates, you are more likely to fall behind on payments.

This attracts late payment fees that add up the cost of the debt and hurt your credit rating as well, killing your chances of taking out a new loan at a lower interest rate.

What are the types of consolidation loans?

If you are looking to merge your outstanding loans into a new loan, choose any one of the following consolidating loans:

  • Balance transfer credit cards

A few credit cards can allow you to transfer the balance and offer an introductory period, also called an interest-free period. If any lender charges interest during this period, it will be very low. Pay off the balance within this period. Otherwise, you will pay off the very high interest.

  • Personal loans

Most of the people choose personal loans to consolidate their debts. These loans merge all emergency loans or small loans like payday loans, unemployed loans and loans of £3,000 with bad credit.

Personal loans do not include credit card debt. They are ideal to apply for when you get them at reduced interest rates. Assess the total interest they will charge and then compare it with the total interest you would pay off otherwise. Go for it if it saves money.

  • Home equity loans

If your house has got some equity, you can use it to borrow money to pay off your existing dues once and for all. Since your house will be put as collateral, you can get these loans at lower interest rates than that personal loans and credit cards. However, in case of default, you will lose your house.

Does consolidation affect your credit score?

Of course, yes, consolidation loans affect your credit score. The following are the factors why you will see a drop in your credit score at the time of applying for these loans:

  • New applications

When you apply for a personal loan or balance transfer credit card, a lender will go through your credit report, which means hard inquiries will be made. They will show up on your credit file for two years. Each inquiry pulls at least five points. Make sure you do not apply to many lenders at the same time. Otherwise, the damage will be even worse.

  • New credit account

Only hard inquiries are not responsible for damaging your credit score. Applying for a new personal loan or a balance transfer credit card means you are opening a new account. It amounts to 10% of your credit score. The more the credit accounts, the lower the credit score will be.

  • Lowers the age of credit

You will likely see an improvement in your credit score when your credit accounts become old, and you have been paying all dues on time. Since personal loans or balance transfer credit cards will be your new account, the average credit will get lower, which pulls your credit score.

As each factor is responsible for hurting your credit points to some extent, you will likely see a significant drop in your credit score, but this is just a temporary effect. Once you start making payments on your debt, you will see your credit points improving.

Bear in mind that your payment history is the biggest factor that accounts for 35% of your credit rating. If you manage to pay down the debt on time, your credit report will do up significantly.

Another positive side of consolidation loans is that they will lower the credit utilization ratio. When you open a new personal account, it increases the credit limit availability and therefore increases your credit score.

Upsides and downsides of consolidation loans

Consolidation loans can help save a lot of money in interest, but you should carefully evaluate the risks too.

You can avail of lower interest rates.If your credit score is bad, you will be charged a higher interest rate.
You have a longer repayment timeframe.Hefty fees will be charged.
These loans can boost your credit score if you pay down the debt on time.You can fall deeper into debt if you fail to manage payments.

The bottom line

Consolidation loans can reduce your credit score, but this is a temporary effect. If you keep paying on time, you will see improvement in your points. However, you should think of consolidation only when you can get a new loan at an attractive interest rate. Debt consolidation loans in the UK with bad credit could be very expensive. Be wary of the consequences of non-payment. Consult a financial advisor if you are unable to make a decision.

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