How to Consolidate Credit Card Debt Without Hurting Your Credit

Keeping up with your debt payments and, ideally, paying down what you owe, is a crucial aspect of your financial life. Staying current makes it easier to rent an apartment, buy a house or a car, or get that next job (or promotion), all of which can pivot on the health of an applicant’s credit score.

However, if keeping up with even the minimum payments is a problem, consider debt consolidation — gathering your unsecured debt (usually credit card balances) under a single loan or payment plan. Understand, however, that debt consolidation can hurt your credit score, at least in the short term.

Does Credit Card Debt Consolidation Hurt Your Credit?

Debt consolidation describes a basket of methods to reduce and eliminate what a consumer owes. These methods won’t crush your credit score:

• Consolidation loans from a bank, credit union, or online debt consolidation lender.
• Balance transfer(s) to a new low- or zero-rate credit card.
• Borrowing from a qualified retirement account, such as an IRA or 401(k).
• Borrowing against the equity in your home or something else of substantial value.
• Borrowing from a friend or family member. (This, plainly, is in almost all circumstances an act of desperation; avoid it if you possibly can.)
• Working with a nonprofit credit counseling organization.

Others — specifically debt settlement — will.

When weighing the options for debt consolidation, it’s a good idea to keep in mind which methods will injure your credit rating, and which won’t. After all, you want to improve your credit life even as you tidy up your messy debt situation.

Credit Card Debt Consolidation Options

Unlike snuggies, movie theater seats, and Burger King Whoppers, credit card debt consolidation is not a one-size-fits-all proposition. Different situations indicate different remedies.

For instance, those making at least minimum payments in a timely fashion who simply want a single payment at a lower interest rate have an inviting range of options. Those who are swamped and in danger of drowning in red ink do not. But even those desperate for a financial life saver have choices.

It makes sense to understand the pros and cons associated with each form of debt consolidation and measure that against your current situation and resources. Remember, there isn’t one method that will solve everyone’s problem.

Debt Settlement: How It Affects Your Credit

By contrast, debt settlement will wreak havoc on your credit score. Yes, even if you’re behind on your payments and maxed out on your credit lines, debt settlement — a method that seeks to get you off the hook for less than you owe — can cause your rating to plummet.

Debt settlement in a nutshell: You, or someone you hire, attempts to persuade your creditor(s) to accept as payment in full something less than payment in full. Don’t be taken in by radio commercials that claim you “have a right” to settle your debt for less than you owe. No such right exists.

So, when you hear others say debt consolidation programs will “ruin your credit” this is the type of consolidation they are talking about. You’re attempting to wriggle out of what you promised to repay. Of course you’re going to get dinged.

Pros:

• If your lender agrees to terms, you will pay less than what was owed, perhaps as much as 50% less.

Cons:

• The interest and late fees for skipping payments could up the amount you owe significantly.
• The fees you pay for the service also cut into the “savings” you get from settlement.
• Your credit score will tumble. How far depends on where you started, but count on falling into the “bad credit” category for a while. If you settle more than one credit card, your score could drop 100 points or more.
• Settlement is a negative on your credit report and stays there for seven years.
• The IRS regards forgiven debt as regular income and it must be claimed on your next tax return.

Debt Consolidation Loan: DIY Pitfalls

Any type of consolidation loan – personal, home equity, HELOC, loan from a 401(k) retirement account —  large enough to cover all your high-interest credit card debt is worth looking into, for several reasons.

Pros:

• Your credit score could get a boost. These loans are considered installment loans, another form of credit that works in your favor when calculating your score.
• Zeroing out your credit cards with a consolidation loan will help the “credit utilization” aspect of your credit score. Not using as much credit is a favorable thing.
• You will trade several monthly due dates for one, possibly for a lower payment than all your credit card minimums combined.
• You probably will save money. The rates on these type of loans tend to be lower than credit card rates, often by half or more.

Cons:

• You essentially trade one loan for another. In other words, you still owe the money, just to one lender instead of five or six.
• If you use collateral – home, car, boat, etc. – to help lower the interest rate on your loan, you could lose that collateral by missing payments.
• There may be upfront costs associated with the loan that add to your debt.
• Debt consolidation loans typically have repayment periods of 3, 5 or 10 years.
• If you continue to use your credit cards during the repayment period, you may end fighting a losing battle as your debt grows again.

Pro Tip I: Once you have used your personal loan to pay off all your credit card debt, do not close those card accounts. At least, keep open the ones that don’t have annoying annual fees. Debt usage and average age of accounts are key components of your credit score. The Big Three credit-reporting firms (Equifax, TransUnion, Experian) regard having lots of room on long-open cards as a sign of credit worthiness.

Pro Tip II: Those credit card accounts you’re going to keep open? Avoid using them. Freeze them in a block of ice. Lock them in a safe deposit box in a bank across town. Cut them up if you must. If you’re an internet shopper — who isn’t? — methodically delete, delete, delete the cards you’ve saved on online retailers’ sites.

OK, keep one all-purpose card for those moments when cash simply cannot be used, such as reserving a hotel room or renting a car. But make sure there’s space in your budget to pay in full whatever balance arrives in the next billing cycle.

The thing about a debt consolidation loan — as wonderful as its potential for righting what’s been wrong in your financial life — is it won’t cure what’s been wrong in your financial life.

Without a firm, strict, downright fanatical commitment to changing the habits that led to your alarming debt load, a consolidation loan can, in short order, turn into nothing more than a temporary relief valve.

Once the consolidation loan is in place, you’ll need reverential discipline — which, let’s face, isn’t much fun and is hard even on saints — to change the spendthrift practices that threatened to overwhelm you in the first place.

Continued poor money management could put you right back where you were before, only with an installment loan demanding its monthly feeding. Miss those payments, and your credit score will crumble.

Debt Management Plan: For Long-term Credit Health

If you have enough income to handle your debt load, and just need some help organizing a budget that you can live with, a debt management program could be the right choice for consolidation.

Debt management plans, also called nonprofit debt consolidation, are administered by nonprofit credit counseling agencies and can help you consolidate debt without have to take out a loan or do lasting damage to your credit score.

Pros:

• You receive a reduction in the interest rate, which should reduce the amount you pay on your debt to an affordable level. In return, you promise you will make steady monthly payments until the debt is paid off.
• Monthly payments are fixed and have a definite end date, usually between three and five years.
• Credit score starts ticking up after 5-6 on-time monthly payments.
• This is not a loan, so you are not adding to or trading one debt for another.

Cons:

• Debt management plans require you to close all credit card accounts involved in the program, which will cause a short-term drop in your credit score.
• There is a monthly fee associated with the program.

However, at the end of the DMP, the notice vanishes with no lasting effect; your score will have benefited by a steady series of on-time payments; and you will be absolutely ready to start afresh, with the knowledge gleaned from your credit counselor, and the experience of having conquered your debt monster.

Should You Try Debt Consolidation?

Plenty of reasons exist for wanting to consolidate debt: lower interest rates; a single, lower payment; a chance to become debt-free on a date certain; breathing room to get reorganized and financially fit; a fresh start; and the promise of a soaring FICO score in the years ahead.

The method you choose for consolidating debt largely depends on your circumstances:

• A loan (personal, home equity, retirement account, credit card transfer) might work for disciplined borrowers.
• Debt settlement might work for those desperate few otherwise considering bankruptcy.
• A debt-management program through a nonprofit credit counseling agency, such as InCharge, is for anyone who wants financial coaching and outside discipline; a professional running interference for them; a real, reliable, workable plan; and a date certain when they’ll be debt free.

If you’re still not certain which method is your best fit, or you want a second opinion about the method you’ve selected, those are even better reasons to begin credit counseling.

Getting the best available advice is the surest way to launch your journey into a secure financial future.