Consolidating debt involves combining multiple debts into one debt. This can be done using balance transfers, personal loans, second mortgages, home equity loans or through a special program offered for student loan debt consolidation. Consolidating debt can help you pay off debt faster, lower the amount you must pay back or lower your monthly payments by stretching out the amount of time it takes to pay your debt. However, consolidating debt can hurt your credit score.
How Does Consolidating Debt Affect Your FICO Score?
Your FICO Score is made up of five factors: payment history, amount owed, age of credit history, types of credit used and inquiries (applications for new credit). 35 percent of your score is determined by payment history: whether you pay on time and whether you have had bankruptcies or judgments against you. 30 percent is determined by how much you owe. 15 percent is determined by the age of your credit history. 10 percent is determined by the types of credit you have. The final 10 percent is determined by inquiries. Consolidating debt can adversely impact your average age of credit (15 percent of your score), your inquiries (10 percent of your score ) and total amount owed (30 percent of your score).
30 percent of your FICO score is determined by your debt-to-credit ratio, or the amount of money owed. Your credit score goes down if you charge close to the maximum amount of credit available to you. So if you have two credit cards with a $100 limit and charge $50 on each, your debt-to-credit ratio may be lower than if you have one credit card with a $100 limit and you charge $100 on that card. When you take out a consolidation loan (either by opening a new line of credit to transfer balances into or opening a personal loan to pay off your debts), you usually use the maximum amount of money offered to you. Thus, you are maxing out that card and adversely affecting your debt-to-credit ratio. This is especially true if you close the old accounts after you transfer the balances to the new consolidated loan.
Inquries and Age of Credit
If you open a new account in order to transfer and consolidate your debts, this new account lowers the average age of your credit history. This factor makes up 15 percent of your score. In addition, when you are applying for the new loan, creditors will usually "pull" (request to see) your credit report. This pull is listed as an inquiry. Too many inquiries can lower your credit score (this factor makes up 10 percent of your score) because lenders may become afraid that you are borrowing more money than you will be able to pay back.