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If you are seeking lower monthly payments, you may be wondering how debt consolidation loans affect credit scores.
Debt consolidation loans can help credit ratings by improving the revolving utilization ratio. However, they may not be able to stop a wage garnishment and could cause problems down the road if you take this step before buying a house.
Debt consolidation loans can be bad for credit if your revolving balances quickly return because of undisciplined spending. Settlement programs and debt management plans can also hurt qualifications – but could result in longer-lasting relief.
Choose the option that optimizes your financing needs at the right time.
When Debt Consolidation Loans Help Credit
There are times when a debt consolidation loan helps credit scores. However, these instances are rare, occur after a time delay, and depend on the spending choices you make afterward.
Many applicants simply do not qualify for a loan. This includes people dealing with garnishment or late payments. Those that are eligible must pay off credit cards and keep the balances low over time. People buying a house find this very difficult to do.
Closing Credit Cards
Request a debt consolidation loan here if you are current on your payments. Use the proceeds to pay down revolving balances without closing any credit cards. Possibly watch your credit score improve slightly. This strategy has three conflicting impacts.
- A hard inquiry appears on the consumer report at one bureau.
- Hurts at the one bureau
- The new personal loan displays your consumer report about one month later.
- Hurts at all three bureaus
- The lower revolving utilization ratio displays about one month later.
- Helps at all three bureaus
Closing credit card accounts after paying down the balances will not help your rating initially. The reason is that your revolving utilization ratio does not improve. The limit drops in tandem with the balance.
However, if doing so prevents further spending it is much better in the long term.
Stop Wage Garnishment
Do you qualify for debt relief? Borrowers subject to wage garnishment rarely qualify for a loan. A settlement program is a more realistic alternative. There is no credit score minimum for this option. People owing more than $10,000 in unsecured obligations are eligible (credit cards, unpaid medical bills, and personal loans).
A debt consolidation loan could stop wage garnishment if you take the proceeds and pay off the creditor in full. This will also immediately improve your credit rating after the old lender reports the paid in full status.
However, this option works only if the new lender agrees to fund the loan. This is very unlikely to happen to people subject to wage garnishment.
- A collection agency probably sued in court.
- The court then issued a judgment authorizing the garnishment.
- This judgment probably appears on your consumer report.
- Which means you have poor qualifications and face a likely denial.
Buying a House
Taking out a debt consolidation loan before buying a house can improve your credit score. On the other hand, it can also affect a second mortgage qualifying criteria. Therefore, educate yourself before taking this fateful step.
Both repeat and first-time homebuyers will find a modest credit rating improvement if they use the proceeds to pay down credit card balances. See the section above. This helps to qualify for a mortgage.
The debt consolidation loan could affect the debt-to-income ratio (DTI), an important mortgage underwriting criteria. The new contract features fixed monthly installment payments. This differs from the flexible payment structure on a revolving contract such as a credit card.
The mortgage company will calculate two ratios. Pay attention to your new monthly payments to determine whether this helps or hinders your qualifications.
- Front-end DTI – includes the mortgage plus homeowners insurance and real estate taxes
- Back-end DTI – includes payments on all monthly obligations
Keep in mind that after buying your house it is very easy to run up new revolving balances. New homeowners often spend money on furniture, repairs, landscaping, etc. This is how debt consolidation loans become bad for credit.
When Debt Consolidation Loans are Bad for Credit
Debt consolidation loans are frequently bad for credit scores. This is often true at the earliest stages. The process begins with a hard inquiry and then proceeds to a new trade line. Both elements hurt ratings for a period.
The impact on qualifications at later points in time depends on the behavior of the individual, and your definition of consolidation. Things quickly go sour if you overspend. In addition, debt consolidation can have three different meanings.
Running up New Balances
Debt consolidation loans can hurt credit scores if the new freedom leads to further borrowing. You must control the urge to spend and take on more liabilities. Otherwise, you will end up in a worse situation than before.
Debt consolidation loans offer two initial benefits that can easily turn into drawbacks.
- Lower monthly payments can make someone feel more financially secure than they really are. If you lengthen the repayment terms, the interest has more time to accumulate. You actually owe more money than before.
- Open to buy on credit cards occurs after you pay down the balance. The open to buy is the difference between the account limit and the amount owed. This makes it easier to spend more money.
- Taking out payday loans during an emergency generates large finance charges and can lead to another debt spiral.
For example, consider the new homeowner mentioned earlier. It is very tempting to use the open to buy on credit cards to finance the new furniture, repairs, and landscaping. If this happens, this person could quickly owe twice as much money as before. This spells trouble.
Consolidating Into Escrow
Debt consolidation hurts your credit score when you delay or reduce payments to creditors rather than retire old obligations immediately. Both consumers and industry providers lump several distinctly different services under one umbrella term.
Be careful to choose words carefully. Debt consolidation can mean three different things.
- An unsecured personal loan offers the opportunity to retire old existing obligations immediately. The borrower takes the funds from lender B to pay off obligations from lender A right away. However, a loan does not eliminate debt. It alters the terms. In addition, it is very difficult to qualify if you are already behind on payments.
- Debt settlement programs degrade payment history but offer lasting relief. During the escrow accumulation phase, the borrower sends one combined monthly payment to the settlement company. The money goes into the escrow account for storage not payment. The purposeful delay in payment causes severe derogatory marks to appear on your consumer report.
- Credit counselor sponsored debt management plan can also degrade payment history. The participant sends one combined monthly payment to the non-profit organization. Often the amount is insufficient to meet every obligation. Therefore, the organization sends a reduced payment to select creditors. This can result in negative marks on a consumer report.
Debt consolidation can be bad for credit ratings if you do not select the program that fits your needs and situation. Choose wisely.