If you have more debts than you can comfortably afford to repay, consolidating these debts into a single loan may not have an immediate effect on your credit score. But if consolidating your debts can help you build healthy financial habits, it’s possible that this could lead to your credit score improving over time.
How do credit scores work?
Credit scores are generated by credit bureaus such as Equifax and Experian using the information in your credit history. If you have a record of borrowing and paying back money on time, you’re more likely to have a good credit score. But if you have missed loan repayments or incurred defaults in your credit history, you’re more likely to have a poor credit score.
Banks, lenders and credit providers use credit scores during loan applications to assess your risk as a borrower. Good credit borrowers are more likely to be offered low interest rates, low fees, or extra features and benefits, while bad credit borrowers may find it more difficult to successfully apply for loans, or may have to pay higher rates and fees.
How does debt consolidation work?
Debt consolidation combines all your outstanding debts into one new loan. This means you’ll have just one repayment to manage, rather than multiple debts to service. You’ll also be charged interest just the once, at the one interest rate, which could be lower than for some of your other debts. This could potentially save you some money, and help make paying off your debt a little easier.
There are a few potential options available for consolidating debts, including:
- Debt consolidation personal loans: These may be secured by the value of another asset, or left unsecured. You may be offered a fixed or variable interest rate, and a choice between a shorter or longer loan term – shorter loans mean higher repayments, but paying less long-term interest, and longer loans means cheaper repayments, but may cost more in total interest charges.
- Balance transfer credit cards: These cards let you move the outstanding balances from other credit cards over, then pay little or no interest for a limited time. This can give you the opportunity to try and clear your debt without it growing larger. However, if you can’t repay the outstanding balance in the interest-free period, you’ll be charged interest on whatever’s left, often at a high rate.
- Refinancing your mortgage: If you already have a home loan, you may be able to use the equity in your property to borrow extra money when you refinance to consolidate other debts. This means you’ll be able to benefit from your home loan’s interest rate, which is likely lower than those of many personal loans and credit cards, though the longer loan term could mean you’ll pay more total interest.
How could debt consolidation help your credit score?
If you’ve been struggling to manage the repayments on multiple debts, a debt consolidation loan could be a first step towards getting your finances back under control. With only one payment to budget for and one due date to remember, it may be simpler to avoid missed payments and to make steady progress towards wiping the slate clean.
If a record of steady and consistent repayments appears in your credit history, this may help to gradually improve your credit score over time.
How could debt consolidation harm your credit score?
Consolidating your debts may not automatically improve your financial situation. Your consolidated debt could take longer to repay, costing you more in total interest, and there may also be other fees and charges to consider. If you miss repayments or default on your consolidated loan, your credit score could be harmed.
Also, consolidating your debts may not matter if you then go out and rack up new debts on loans and credit cards. To help limit the risk of restarting the debt cycle and leaving you stuck in the same position or worse off, you may consider cancelling credit cards and other loans and credit accounts once you have consolidated your debts.
Consider contacting a financial adviser for more information on whether consolidating your debts may be the best choice for your financial situation. For example, a mortgage broker may be able to offer advice around refinancing options. And if you find yourself in financial distress, the National Debt Helpline may be able to provide financial counselling.
