Does Debt Consolidation Hurt Your Credit?

Lisa quit her job a year ago to care for her suddenly ill mom, who now needs hospice/end-of-life care.

In the process, she neglected her finances and ran into some scary debt.?

Lisa has 40K in credit card debt, which has tanked her credit. Her credit score was 750, and now it’s 608.?

She needs help weighing her debt consolidation options to determine whether it can help or hurt her credit.?

Let’s explore debt consolidation options to see if this will be a good fit for Lisa.?

Disclaimer- This information is for educational purposes only. This is not legal or financial advice. Please consult with a financial professional for guidance on your specific situation.

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I. What is debt consolidation?

If you have multiple debts, you can consider debt consolidation to make your monthly payments more manageable. Debt consolidation involves taking out a loan to pay off all your debts, which can result in lower interest rates or monthly payments. Personal loans or credit card balance transfers are common ways to consolidate debt.

A. What is the importance of a credit score?

It's important to maintain a good or excellent credit score, as it reflects your history of paying debts and bills on time. A good credit score can lead to lower interest rates and better financial opportunities.

II. How Debt Consolidation Works?

A. Types of debt consolidation

There are seven ways that you can consolidate your debt. Let’s discuss the pros and cons of each.

Balance Transfer Credit Card

Pros:?

1. You may be able to get 0% APR for a limited time
2. Usually offer more flexible payments than a loan
3. There is no prepayment penalty
4. You are consolidating your debt into one monthly payment

Cons

1. You may have to pay a balance transfer fee that can range from 0-5%+
2. Your score could drop if you continue to use your new card balance
3. If you don’t pay off the debt before the introductory period ends, then you will pay interest on the debt
4. You will get a hard inquiry on your credit report that can impact your score short-term

Personal Loan

Pros

1. Could reduce your interest rate
2. It can help you to obtain a credit mix if you only have credit card debt
3. Can combine your debts, helping you to make one monthly payment
4. It may help to improve your credit

Cons

1. You can get into more debt if you aren’t disciplined
2. If you can’t keep up with the payments, mixed payments will hurt your credit
3. You may pay higher fees if you don’t understand the fine print
4. You may have to pay fees, such as origination fees and prepayment penalties, for paying off your loan early

Home Equity Loan or Home Equity Line of Credit (HELOC)

Pros

1. An easy way to pay off your debt with a low interest rate
2. You can combine your debt to make one payment monthly
3. The loan is tax deductible as long as you don’t borrow more than 100K
4. You will generally pay a lower monthly payment since you have a low interest rate

Cons

1. You could lose your home if you can’t make the payments
2. If you sell your home and can’t sell it high enough, then you are still responsible for paying the remainder of the loan off
3. You could be penalized for paying off the loan early
4. You may have to pay fees, such as closing costs, an origination fee, a home appraisal fee, and a credit report fee

Debt Consolidation Loan

Pros

1. Collateral of assets is usually not required
2. You can usually get approval and funding quickly
3. It usually offers lower interest rates than credit cards
4. You can usually borrow $1000- $100,000

Cons

1. Associated fees include an origination fee, late payment, and prepayment fee.
2. You will need excellent credit to get the best interest rates
3. Your loan term could be longer than your debt obligation timeline
4. Many scams pose as debt consolidation companies, so beware

Peer-to-Peer Loan

Pros

1. The application and approval process is typically fast
2. A soft credit check is used
3. You may be able to qualify with a lower credit score
4. You have a wide range of purposes you can borrow for

Cons

1. Fees may apply
2. You may have to pay higher interest rates if you have bad credit
3. Typically, higher monthly payments
4. Less time to repay loan compared with other options

Debt Management Plan

Pro

1. Your credit score can increase over time
2. Some organizations offer free help
3. You could be eligible for some of the best loan rates
4. You can generally become debt-free within five years

Cons

1. Your credit score will temporarily be lowered
2. You may have to stop using or close existing credit cards
3. You can’t apply for any new lines of credit, such as personal loans or auto loans
4. Not all of your debt will be eligible to take advantage of this plan, such as student loans and secured loans

401 (k) Loan

Pros

1. Most fund administrators offer flexible repayment options with no prepayment penalty.
2. You may pay a very small or no origination and admin fee, one of the most inexpensive options for borrowing money.
3. Borrowing money that you will pay back won’t typically have an impact on your retirement.
4. You can usually borrow up to $50,000 or 50% of your account

Cons

1. If you are younger than 59 ? and don’t repay the entire balance borrowed, you could be subject to a 10% penalty on the unpaid balance.
2. For every dollar you borrow that you don’t pay back is one less dollar that goes towards your retirement.
3. If your employer matches your contribution, it could be paused while you repay the loan.
4. If you quit, get fired, or get laid off, your employer could demand that you pay back the entire balance between 30-90 days.

III. How does Debt Consolidation Impact Your Credit Score?

A. Short-term effects

• You may pay more upfront fees, such as balance transfer fees, annual fees, closing costs, and origination fees.
• You will get a hard inquiry on your credit report, dropping your score a few points and lasting two years.

B. Long-term effects

• You may pay a higher interest rate than your previous debt if you have bad credit.
• If your debt is about to get canceled due to the statutes of limitations, it will reset to day one, possibly having you pay seven more years toward that debt.

C. Factors that affect credit score

• Payment History- 35%
• Amounts Owed- 30%
• Length of Credit History- 15%
• Credit Mix- 10%
• New Credit- 10%

IV. What are Tips to Minimize Negative Effects of Consolidating Debt?

1. Never accept an interest rate that is the same or higher than your current debts.?

• When you inquire about the new interest rate, ask what is being offered and how long the rate will last.?
• Also, find out the rules to keep your interest rate low, such as how much it will increase if you are late even once!
• Ask when your interest will accrue after the transfer
• Find out how much the balance transfer fee
• Find out what methods they will use to calculate your monthly payment amount. Stay away from institutions that use the two-cycle average daily balance method
• Ask if the grace period is 20, 25, or 30 days. Aim for the one with a 30-day grace period

1. Make sure your interest rate is fixed and not variable
2. Don’t apply for any new debt until you have paid off your consolidated debt

A. Payment strategies

• Setup automatic payments
• Create bill reminders on your phone

B. Credit monitoring

• Get your free credit report at https://www.annualcreditreport.com/index.action
• Check with your bank or credit union about getting your FREE FICO score.

C. Budgeting

• Evaluate your budget
• Monitor your spending habits

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Bottom Line

If you have good or excellent credit and want to pay down your debts faster, then debt consolidation is best for you. Read the loan terms and fees carefully, set reminders to pay your bills on time, create a budget, and stick to it!?

If you get stuck along the way, look for a highly recommended credit counselor, or if you already have a financial advisor, speak with them about what options will work best for your situation.

So, what do you think is Lisa's best debt consolidation option? Be sure to let me know.