Money

Debt Consolidation: Will It Help My Credit Score?

Debt Consolidation: Will It Help My Credit Score?

It’s no secret that our credit scores are utterly dependent on a lot of factors, both within and outside our control. As for the factors that we can control, none have a bigger impact than the way we manage debt. After all, debt is inescapable when you are a credit holder but the way you manage it determines whether your obligations would hurt your credit score or not.

One of the strategies that deal with debt management has been to consolidate all debts and put them into one account. This, however, begs the question: does it actually work? In order to answer that question, there are several basic concepts that we have to go over first.

How Debt Works

To describe it in the simplest terms possible, debt is any amount that you are legally obligated to pay a person or company and is born out of a transaction you made with them in the past. To put it even more simply, if you are allowed to enjoy something and not asked to pay for it immediately, the amount you have to pay them eventually becomes your debt.

So why is debt inescapable in the world of credit? It’s simple really: the entire system is built around it. To use your credit card, you need to fill it up with credit. And credit, in turn, is something that you can only loan from a credit issuing company.

Of course, debt with a credit card is not only created from applying for credit loans. You can have that credit card attached to any service or membership you are subscribed to which you’ll have to pay on a monthly basis. If you don’t have enough credit to pay for them, any outstanding balance you have for that month automatically becomes your debt in the next billing cycle.

How to Usually Eliminate Debt

When faced with financial obligations, especially if they become too big and too many, a person usually has to decide from three courses of action.

1. Declare Bankruptcy

When you declare bankruptcy, you are officially telling your creditors that you no longer have the means to pay for your obligations. This means that you are no longer legally obligated to pay for most of your debts.

However, there is a catch: Declaring bankruptcy is a serious derogatory remark on your credit history. This means that your credit score will drop by several hundred points and even go down to the 300-500 mark (very poor to poor) range depending on the circumstances of you bankruptcy. This can seriously affect the way you can get credit in the future.

Also, there is the fact that declaring bankruptcy for the sole purpose of avoiding your obligations is generally considered a bad decision in countries like the UK. The court might even order that remaining assets be confiscated from you and used to repay your debts, leaving you virtually penniless.

There is also the fact that declaring bankruptcy to defraud creditors is a major crime in the UK. So, if you are caught, you will not only incur your primary liabilities (the amount you owe) but also civil liabilities (the amount you pay for the damages you have caused in your act) and criminal liabilities like prison time.

2. Ignore It

If declaring bankruptcy to avoid creditors is bad, ignoring your debts is worse. Technically speaking, every derogatory remark made on your credit history will only stay there for 6 years at most. This means that your delinquent payments would stop affecting your credit score after that period has passed.

The problem? That won’t stop creditors from hounding you and forcing you to pay up. Also, in the meantime that the 6 years has yet to pass, your credit score will suffer tremendously.

Your next option here is to move to a different country where credit laws are far more lenient than in the UK. But, based on our discussions on Brexit, that option might no longer be available if the UK truly leaves the rest of the European Union.

3. Pay It

Out of the three courses of action you can take, this is by far the most sensible one. Of course, this will require a plan on your part since there is no way that you can remove all of that amount with just a single payment.

The best way to tackle your debt is through a two-pronged approach. First, you have to find ways to earn more. Through this, you can have more than enough money to spend paying down your debts. This also works if you can also find ways to lessen other expenditures.

Second, you must make sure that the overall cost of the debt is reduced gradually. This way, a major portion of each payment you make to the debt is applied to the principal balance.

There are many strategies that you can take in order to reduce the amount you owe or, better yet, remove everything in a synchronous and gradual manner. The latter is where debt consolidation can be classified under and will be discussed thoroughly in the next few sentences.

Can You Be Relieved Of Your Debts? 

Let’s get this out of the way, first. Not all creditors out there are going to be ruthless when demanding payments. Some might allow you to pay everything in small installments or even absolve you of your financial obligations.

However, these people are the exception, not the rule. Aside from that, you’ll have to be in serious arrears and convince that lender that you have the ability to pay for your debts, not just in the pace that they would want you to take for it. That being said, it’s best not to expect that your creditors are going to be lenient with you if you ever rack up a lot of debt.

How Does Debt Consolidation Work?

Debt consolidation is usually provided in the form of a program where you are given the chance to pay off all your debts in one instance. This is through taking out one loan large enough to pay every debt you had ever made.

Simply put, you are going to pay every debt you have ever made by loaning an amount that is equal to the total sum that you owe to all your lenders. The consolidation part comes from the fact that every amount that you have owed to a lender will be transferred to a single, large account.

As for interest rates, debt consolidation loans have lower monthly interest rates compared to most of your debts. As such, you should have no problem dealing with the interest if you do get your debts consolidated into a single loan.

Sure, you are just trading your loans for a bigger one which means that you are not technically forgiven of your debts. However, this should allow you to focus one big creditor with a singular interest rate as opposed to multiple creditors with their own interest rates and deadlines.

How it Affects the Credit Score

In most cases, a debt consolidation loan affects your score in a positive way. How it works is quite simple: lenders always mark every payment that you make for your debts as a positive entry to your credit history, regardless of how you got that money to pay for it.

The money you acquired from the loan will then be used to pay off all your debt accounts. Of course, every payment will be regarded as a good entry which means that multiple payment entries should allow your credit score to move several points up. Do it right and you might just have your score back to the above average to excellent range of 650-850.

Of course, the debt consolidation account is a separate credit account. This means that you will have to pay for it eventually or else your credit score will drop again. However, you should find paying multiple payments on time for a single credit account to be far more manageable than paying for several of them at once.

This strategy will take some time before you can see any considerable increase in your score and will require consistency on your part. However, the boost in your credit score should be considered once all of the payments you have made will be factored in to your next credit report.

Other Benefits

Aside from helping you clear multiple accounts at once, debt consolidation should help you as far as your debt management strategy is concerned. How it does this is through simplifying your list of lenders.

Think of it this way: having a list of debts from multiple lenders means that you have to deal with multiple people with multiple standards and varying levels of tolerance. Some might forgive if you miss a single payment while some will insist that you don’t miss a single second on your dues.

Also, multiple lenders mean multiple interest rates. Depending on that lender, they might fix a high interest rate on your debt so you pay on time (and they will earn money from investing on you). Either way, you can expect to pay more than the total amount of money you owed to that lender once you cleared the account.

By consolidating your debts, you effectively put all of your primary debts into one account. The interest rates for each as well as the deadlines have all been erased by virtue of that debt being technically paid.

Another benefit is the fact that most debt consolidation loans have lower interest rates than your typical loan. It also does not increase as time passes. Whatever interest rate you signed up for remains the same until you pay the last penny.

Things to Consider

So is Debt Consolidation the best strategy out there? Not really. Like every other debt management strategy, debt consolidation only works if you meet certain conditions.

1. Timeliness of Payments

Since you’re trading multiple small debts for one large debt, you are still obligated to pay the amount you have agreed to pay as the minimum on monthly basis. In fact, missing a single payment for your debt consolidation account tends to lead to a bigger drop in points to your score when compared to a smaller debt.

2. Keeping Your Credit Accounts Open 

If your debt management plan involves the closure of several of your credit cards, you need to be careful which cards you will keep open. Even if your aim is to discourage yourself from spending recklessly, there are some instances when closing your credit cards will negatively impact your score which negates the purpose of a debt consolidation loan.

The reason for this is the credit utilisation ratio which is a massive factor in computing your score. Since this is computed through the amount of credit you have versus the credit you have used in that period, a good credit utilisation should feature a balance between used and available credit. What happens, then, if you close a card that contains a lot of available credit? That balance would have shifted and your score would plummet.

Also, do not close cards that have been with you for longer than 5 years. For instance, your first credit card marks the beginning of your entire credit history. Closing that effectively chops off major portions of your history, shortening it. Of course, shorter credit histories tend to lead to lower credit scores.

If you do have to close some of your credit cards, it would be better that you close the ones that have minimal to no available credit and are the ones that you recently opened.

Should You Consolidate?

However, the biggest question you might have is whether or not you should even consider debt consolidation as a viable strategy to manage your debts. This has nothing to do if you qualify for the plan as debt consolidation companies have their own standards for that.

What this does concern, however, is if you have what it takes to use this strategy to your advantage. To answer that, there are several more things you have to consider.

Your Credit Habits

Are you the type of person that gets loans for your debts, pays them, and then quickly goes back to charging these credit cards again? If your answer is yes, then consolidation is not for you.

The key to making debt consolidation work is to not create new entries into your list of debts. If you can’t avoid using your credit cards often, then do yourself a favour and close the ones that are the riskiest to your score.

Of course, this means that your score is going to drop. But that will also mean that you allow yourself some breathing room to regain your senses and get your finances back to manageable levels.

Commitment

Since it’s still debt, a consolidated debt plan requires you to be as consistent as possible when making your payments. Prior to getting the loan approved, you would have to sign an agreement stating that you will pay a certain amount of money in minimum for every month over a considerable period of time to clear your new debt.

If you find yourself able to pay your debts on time, then consolidation might work well for you. Keep in mind that lenders only report payments to the credit reporting agency if they were made on or before due dates. That consistency would eventually help you improve your score with the agencies whilst also removing entire portions of your debt from your history.

3. Your Patience

A debt consolidation plan is something that is effective when done over a long-term basis. You can’t expect for your credit score to improve with this strategy immediately on the next credit report. The changes will be gradual according to the amount you have to pay every month.

However, you can be certain that your score gets increased by several hundred points upwards the moment that you have paid the consolidated debt in full. Of course, this is assuming that you never incurred other types of debt before that.

In Conclusion

So is debt consolidation a great strategy in improving your credit score? The answer is yes but its effects can go beyond that. Aside from helping you improve your score, it makes the entire experience of managing your financial obligations all easier and simpler for you.

Of course, having to pay a considerable amount of money for the new debt will compel you to develop better financial habits such as finding more sources of income whilst also lowering your expenditures.

The point is that consolidating your debt is a far better option than declaring yourself bankrupt or just plainly running away from your obligations. The assistance of a debt counselor can also help in giving yourself a better rate in the reporting agencies as well as becoming a smarter credit holder.

Have you considered consolidating your debts? What other measures do you think are effective in managing your finances and improving your credit score? Let us know in the comments section down below.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Leave a Comment: