Debt consolidation is a popular strategy that many use to combine several high-interest debts into a new loan with a much lower interest rate. In addition to helping you save money on interest, debt consolidation can also improve your credit score by consolidating debt, making your debt easier to manage. Instead of having several monthly payments to worry about, you will only have one payment.
Although there are several benefits to consider, something you may not know about is how consolidating debt and credit score are related, both working hand in hand to improve your financial health. This is an important consideration for obtaining future loans and other things.
Continue reading to learn about the relationship between debt consolidation and credit score.
How Do Credit Scores Work?
A credit score is a three-digit number that ranges from 300 to 850 that is calculated based on your financial history. It is used by lenders to determine your level of financial risk when considering you for a loan. The higher your score, the greater your chances of loan approval.
In the US, three credit reporting bureaus assign credit scores—Equifax, TransUnion, and Experian, and they each could assign slightly different scores. This is because not all businesses report to all three bureaus. Some companies only report to one or two.
Your credit score is not something you want to take for granted. In addition to being an important factor in obtaining loans, your credit score may also be checked to:
- Land a job
- Obtain utilities
- Rent an apartment
- Acquire a cell phone
- Get a good rate on your car insurance
So, not only can a low credit score prevent you from obtaining a loan, but it can also cause problems in other areas of your life.
How Are Credit Scores Determined?
To understand how debt consolidation can improve your credit score, it’s important to know how credit scores are determined and the factors that can cause them to either rise or fall. Five things influence your score, and they each make up a different percentage of the total.
Payment History
Your payment history makes up 35% of your credit score and represents how well you made timely payments on your previous debts. The reason why it is such a large part of your credit score is that how well you managed your previous debts is considered a good indicator of how well you will manage your future debts.
Credit Utilization
Coming in at a close second, credit utilization makes up 30% of your credit score. This metric refers to how much of your available credit you are currently using. If you have a credit card with a $20,000 limit, for example, and you currently have $6,000 charged to it, your credit utilization is 30%. The lower your credit utilization, the better it is for your credit score.
Length of Credit History
How long you have had credit makes up 15% of your credit score. Similar to your payment history, demonstrating that you can manage your credit responsibly over time will boost your score.
Credit Mix
Making up 10% of your credit score, the credit mix refers to having different kinds of credit. This could include credit cards, personal loans, student loans, and other forms of debt.
New Credit
New credit represents how many new accounts you have established in the past year, and it makes up 10% of your credit score. Opening too many new accounts in a short time could negatively impact your credit score.
How Can Debt Consolidation Improve Credit Score?
Although it may sound counterintuitive, taking out a personal loan to consolidate your debt may improve your credit score. Two factors contribute to this—improving your credit utilization ratio and making timely payments on your new loan.
Improving Your Credit Utilization Ratio
As previously mentioned, your credit utilization ratio makes up 30% of your credit score, which is significant. Because it accounts for such a large percentage of your score, you want to keep it as low as possible. Even small changes in this ratio can impact your score.
When you take out a personal loan to consolidate your debt, you aren’t just transferring your existing debts to a new loan, you are also freeing up the available credit on your credit cards and other lines of credit. To the credit reporting bureaus, it will appear as though your credit utilization ratio suddenly went down, which may result in a credit score increase.
Making Timely Payments On Your New Loan
Keeping up with multiple debt payments each month can be a big headache, and it’s easy to occasionally miss a payment or have a late payment. These missed payments can negatively impact your credit history, which makes up 35% of your credit score.
By consolidating your debts into one convenient loan, you can more easily manage your finances by only having to remember one monthly payment. Although it may take some time, making timely payments on your new loan will help to improve your credit score.
Simplify Your Life With a Debt Consolidation Loan
There are several important benefits to consider with debt consolidation. Yes, you may be able to improve your credit score, but you could also save money on interest if you replace high-interest credit card debt with a low-interest debt consolidation loan.
Managing your debt is also easier with a debt consolidation loan. You no longer have to keep up with multiple due dates, and you can repay your debt with fixed monthly payments. This helps with budgeting, and it also allows you to mark on your calendar the date that you will finally be debt-free.
If you are thinking about consolidating your debt, TEG Federal Credit Union offers a low-interest loan that you can apply for in-person, by phone, or online. TEGFCU also offers a free credit review if you aren’t sure which debt payoff strategy is best for your situation.
The following article discusses several popular debt payoff strategies that have been proven to work. With the right strategy, you can work on eliminating debt to qualify for a mortgage or another reason.
