You can’t turn on your television or fire up a browser without seeing an advertisement extolling the benefits of consolidating your debts—and a loan offer to help make it happen. The value proposition for consumers who qualify for these loans is pretty straightforward: cheaper debt is better than more expensive debt. By moving an outstanding balance on a higher-interest loan to one with a lower interest rate, you can save a significant amount of money.
Examples of debt consolidation can include paying off multiple high-interest credit cards with a newly opened low-interest credit card, or paying off multiple student loan obligations with a home equity loan or line of credit. Most, if not all, large credit card issuers offer a “no interest” balance-transfer option. This allows consumers to move their balances from existing credit cards, with interest-accruing balances, onto a newly opened credit card, on which no interest is charged on either the transferred balance (or any additional purchases made) for a period of up to 18 months. That’s a great way to reduce your monthly payment obligations and more quickly pay off the balance owed.
But how will your credit score be impacted if you do this? Regular readers of The Score know that applying for and accepting new credit can cause a dip in your credit score—one that typically recovers within a few months, as long as you continue making all your payments on time.
Setting aside those temporary downturns, debt consolidation could bring a significant improvement to your credit score. It’s no secret that credit card balances at or near the borrowing limit can lead to significantly lower credit scores, especially if several cards are close to their reported credit limits. The metric in question here is what’s formally referred to as your revolving utilization ratio or, more informally, your debt-to-credit limit ratio. The higher that ratio, the more problematic for your credit scores.
This metric, which is extremely influential to the calculation of your credit scores, only considers the balance and credit limit information on credit cards. This would include general-use cards like Visa, MasterCard, Discover and some American Express products. It would also include gasoline cards and retail store cards, as long as they have revolving terms.
If you have several credit cards with balances and you use a personal loan to pay them off, you’ll accomplish two things that are both very helpful to your credit score. First, you’ll reduce the number of accounts with a balance greater than zero. Second, and more important, you’ll be reducing that influential debt-to-credit limit ratio, perhaps to zero if you pay off all of your credit card debt with the personal loan.
Another way debt consolidation can positively influence credit scores is by improving the mix, or variety, of loan types in your credit file. Credit scoring models typically reward a blend of different credit types—some combination of revolving credit—loans like credit card accounts, in which the loan amount can vary over time, and installment loans in which you pay off a fixed loan amount in a set number of monthly payments, or installments. Using a personal loan to pay off credit card balances converts revolving debt to installment debt and increases your credit mix. Doing so can be very helpful to your credit scores, despite the fact that it doesn’t reduce your overall debt by even one penny.
All of which suggests a couple of caveats: First, make sure you read and understand all the terms and conditions of any new loan, including the nature and duration of any low- or zero-interest-rate introductory periods, to avoid unexpected fees or penalties. Second, and we hope this is fairly obvious: If you qualify for a loan that helps you reduce your credit card debt and raise your credit score in the process, don’t take the resulting improvements for granted. Try to avoid accumulating additional debt—and especially running up additional high card balances, until you’ve paid off, or at least made significant progress against, that consolidation loan. And once you’ve caught up with your debts, take care to avoid running up excessive balances in the future. You’ll be rewarded with steady improvements in your credit score.