Consolidating debt seems to be the best strategy when you have multiple short-term, high-cost debts due on different dates. Falling behind on the due date means rolling over a loan, which quickly adds up the cost of the debt. Each missed payment causes a loan to snowball into a larger debt. In order to avoid tackling accumulated debt, consolidation seems to be the best alternative.
What exactly is the consolidation, and how does it work?
Consolidation debt is not a distinct type of loan. It refers to the process of combining all outstanding debts into one large personal loan so you can manage payments. Consolidation is aimed at lump sum loans such as payday loans, bad credit loans, instant loans and small emergency loans.
When you combine all of them, it means you use your personal loan to settle all outstanding dues once and for all. Then, you are left with only the payment of a personal loan, which is paid back over a span of months. Consolidation is often recommended as it spreads the cost of the debt. Consolidation can also help you save money as they charge lower interest rates than those of short-term loans.
Now the question is how consolidation will affect your credit score. It is vital to note that these loans are available to borrowers with good credit history. People with a subpar credit rating will not be able to qualify for consolidation. Some lenders are out there who might feel inclined to sign off on debt consolidation loans for bad credit in the UK from a direct lender, but they will restrict the loan amount and charge high interest rates.
It means you will be highly likely to be unable to consolidate all outstanding debts and pay interest more than you otherwise would.
How debt consolidation helps with your credit score
Debt consolidation can help you with your credit score in several ways:
Lower credit utilisation ratio
If you have an outstanding balance on multiple cards, you can apply for a 0% balance transfer card, provided your credit score is not subpar. The greatest benefit of these cards is that you will be able to settle the whole balance without paying interest. However, you will be required to discharge the whole balance within the introductory period, and you will end up paying a lot more money in interest.
Transferring your credit card balance to a balance transfer card with a higher card limit will reduce your credit utilisation ratio. It helps improve your credit score. You will see a significant improvement in your credit score when you discharge the whole of the balance.
Manageable payments
Consolidation loans include fixed monthly payments over an extended duration. If you pay down the whole debt on time, this will build a positive payment history. Your payment history makes up 35% of your credit score. Therefore, you will see a significant improvement in your credit score.
Credit mix
A credit mix is also an important factor, though it accounts for only 10% of your credit score. When you have short-term high -cost debts and revolving credit, it does not reveal much about your behaviour of handling instalment debts.
When you consolidate your existing debts into a personal loan, you will have both revolving credits and a personal loan. This will help slightly improve your credit score.
How debt consolidation hurts your credit score
Though consolidation loans help improve your credit rating to some extent, they also reduce your credit score.
New credit inquiries
When you apply for a personal loan or a balance transfer card to consolidate your existing debts, a lender will make fresh inquiries to know your credit rating and repayment capacity. Hard inquiries will be recorded on your credit file, which might knock off a few credit points. These hard inquiries will not affect your credit score much, especially after you discharge the debt.
A lower credit age
In order to consolidate your debts, you will need to open a new account. It means your existing accounts will be closed. Since a personal loan and balance transfer card will be recent, the average age of your loans and credit cards will fall steeply. The length of a credit history is a paramount factor when it comes to boosting your credit score.
A higher credit utilisation
There is a high probability of increasing your credit utilisation ratio. If you transfer your credit card balance to a 0% card, this will increase your credit utilisation ratio. Balance transfer cards do not come with a high limit. They are generally aimed at helping you to settle your credit card debt. It is likely that they do not have the total limit equivalent to the combined limit of standard credit cards. As a result, your credit utilisation ratio steeply rises. The higher this ratio, the worse your credit score is.
The bottom line
Consolidating existing debts will certainly help you manage your high-interest debts as it spreads the cost, but it affects your credit score, too. At the time of taking out a consolidation loan, bear in mind that they do not reduce your debt amount. Further, there is no guarantee that a lender will consolidate all of your existing debts.
Generally, lenders do not lend beyond £1,000, which means the remaining debt amount will have to be handled separately. In this scenario, you will likely find it even more expensive. If you transfer your credit card balance, you might be tempted to use your current cards. As a result, you will max out your credit card.
It will not be possible every time to get approval for a balance transfer card. If you have debt problems, you should consider other options, such as a debt management plan and declaring bankruptcy, but bear in mind that they both have serious consequences on your credit score. You should choose these methods only as a last resort. Talk to a debt consultant if they can give you some meaningful advice on debt management.
