Debt Consolidation: How Does it Work and How Does it Affect Your Credit Score?

how does debt consolidation work

Whether you have a troubling amount of student loans or a taxing load of monthly credit card payments, debt can be stressful. If you are like most people, you probably sincerely want to get out of debt. Debt can zap your bank account, suck up all of your disposable income and, to add insult to injury, can often hurt your credit scores.

Yet short of writing a big check to pay everything off, what can you do? The answer to that question is going to depend on a variety of factors. However, if your credit is currently in decent standing and your income is sufficient, a debt consolidation loan may be a viable option to consider.

What Is Debt Consolidation?

The term “debt consolidation” is thrown around liberally to describe a variety of things. But, in this context, debt consolidation is simply taking out a new loan to pay off previously existing debts. It is borrowing from Peter to pay Paul, but at a better rate and with a lower monthly payment requirement. If your new consolidation loan has better terms than your existing obligations, you may be able to strategically use it as a tool to help you get out of debt more quickly and less expensively.

For example, if you have credit card debt, you’re likely paying between 16 to 24 percent APR (Annual Percentage Rate) to service the debt. That’s likely the most expensive debt you’ll ever carry. If you took out a debt consolidation loan at 7.9 percent and paid off your credit card debt, you’ve just cut your interest load by half, or more. Same amount of debt, better terms.

Does Debt Consolidation Hurt Your Credit?

If you are worried that a debt consolidation loan is going to harm your credit scores, you probably shouldn't be. To the contrary, your credit scores might actually increase and increase considerably. The reason is you’ll be converting credit card debt into installment loan debt.

Credit card debt is unsecured revolving debt, a distinction that is important where credit score calculation is concerned. Even if you pay your credit card minimums on time each month, your credit reports will still display the outstanding credit card balance. And because revolving debt is more predictive of elevated credit risk, scoring models are designed to penalize you more because of it.

Installment debt, on the other hand, is not as predictive of elevated credit risk. Therefore, if you use a consolidation loan (installment) to pay off credit card debts (revolving), you might be able to improve your credit scores simply by moving the debt off of your credit cards and onto a new loan. You’ve just converted high-risk debt into low-risk debt.

Debt Settlement Is Not The Same As Debt Consolidation

There are companies who, for a fee, may offer to consolidate your monthly payments and negotiate with your creditors on your behalf. These companies offer what’s called “debt settlement.”

Debt settlement companies traditionally charge fees and may advise you to stop making payments to your creditors to get the companies "desperate" enough to accept an offer to settle your outstanding debt at a reduced amount. However, if you follow this advice, you could wind up with a string of late payments across multiple accounts on your credit reports. You might save some money, butyour credit scores will suffer. And frankly, you can negotiate settlements on your own and save the fees.

You should also be aware that if you do choose to follow their advice and ignore payment demands from your creditors, they may sue you. If your creditors sue you, your options become limited and expensive, including hiring a lawyer. Debt settlement isn’t always a bad option, but it should be one of your last options.