Did you know you can accomplish the tasks of making it easier to pay off debt and improving your credit at the same time? It might seem too good to be true, but one good financial turn often leads to another. In the case of paying off debt, your credit can improve as the debt goes down.
However, paying off debt is rarely a short or easy road. That’s where it helps to learn how to consolidate debt. When done strategically, debt consolidation can help you lower the interest you’re paying on debt and provide a path for paying it off. And, as you do, your credit can experience an upswing as your balances go down each month. This is what you call a win/win, and this is how to start.
How to consolidate debt
There are a few ways to consolidate debt, and it’s important to choose the one that meets your specific needs. Consolidating debt is just as much about the follow-through as it is about the lowering of interest rates, and it helps to know yourself and what you’ll most likely stick to. Some options to consolidate debt include:
Consolidate your debt with a balance transfer credit card
Consolidate your debt with a personal loan
Consolidate your debt with a line of credit
Note that the consolidation process is different if you have student loan debt. Most federal student loans can be consolidated with something called the Direct Consolidation Loan. If you have private student loans (and if you have federal), you can refinance them through various student loan refinancing companies, such as SoFi and Earnest.
Typically, though, debt consolidation refers to the consolidation of consumer debt such as credit cards. This can be helpful because high credit card interest rates are a big part of what makes them hard to pay off, and consolidation products with lower rates can be a game-changer for the entire process. Below are more details on the products that can help with this.
How to consolidate debt with revolving credit
A balance transfer credit card is the main type of revolving credit used to consolidate debt. How it works is you’d apply for the balance transfer credit card of your choosing, and, if approved, use it to pay off your other debt. Then you’d repay the balance transfer credit card.
The reason this can work well is because balance transfer credit cards typically come with an offer of no interest for a certain period of time. As long as you pay the card in full by the end of that time, you’ve given yourself an interest-free period of time with which to pay off your debt. If you can’t pay it off in time, you’ve still made a bigger dent on the principal than you would have if you kept your debt on the original, interest-bearing account.
In theory, you could use other lines of credit to pay off debt if they offer lower interest rates than what you’re currently paying. Home equity lines of credit (HELOCs) would be an example of this, but they come with more risk. If you’re using credit tied to collateral (such as your house) to pay off debt, then you have more to lose (such as your house) if you default. That is not a risk you’d typically run with a balance transfer credit card since a balance transfer credit card is unsecured debt (meaning it’s not tied to collateral of any sort).
How to consolidate debt with a personal loan
Another way to consolidate debt is through a personal loan (which is also typically an unsecured type of credit, and therefore not tied to collateral). Personal loans aren’t likely to come with introductory zero percent interest offers, but what they can come with is a fixed payoff date. This can be nice for the debt repayer who fears falling deeper into revolving debt.
How this works is you’d apply for the personal loan of your choice, and the loan would then be used to pay off your other debt. You’d then repay the loan according to the schedule laid out in your loan terms, and you’ll be debt-free by the end of that term as long as you always make full payments on time and don’t add any new debt onto the card or cards that were paid off.
This last point is crucial to any debt consolidation product you choose. A loan or line of credit can be used to pay off old credit card debt, but there’s nothing stopping you from accruing new debt on that paid off card but you. It takes diligence to ensure that you’re not acquiring any new debt while you work to pay off the old.
How consolidating debt can improve your credit
As mentioned, debt consolidation isn’t just a tool that can help you pay down high-interest debt; it can also help improve your credit while you pay down that debt — assuming, that is, that you don’t add new debt to the debt you consolidated.
The most impactful way debt consolidation can help improve your credit is that it helps you pay down your debt — and that has an especially large impact on credit when the debt being paid off is credit card debt. Credit card debt is factored into something called your credit utilization ratio, and the lower that ratio, the better your credit scores can be.
For both FICO® and VantageScore® (two main consumer credit score companies), credit utilization ranks highly on influential factors for your credit scores. Any action you take towards paying down your debt can help your credit scores, so long as you don’t add any additional debt to the mix.
Debt consolidation can also help your credit in a smaller way if you choose to use a personal loan to pay off debt. That’s because adding a loan onto a credit file that has only revolving debt improves your credit mix, a factor in your credit scores. Lenders like to see how you’ll handle different types of credit, so having more of a credit mix can help in that sense. That said, this factor is a small one for FICO® credit scores, and it may not be influential enough to take out a loan just to improve your credit. Consider it instead to be a helpful byproduct if you were already planning on using a personal loan to consolidate your debt.
One good financial turn leads to another
In the effort to improve credit, it’s easy to get caught up in things that you think might marginally help but aren’t necessarily good for your finances. The truth is, whatever is good for your finances is likely also good for your credit.