Debt consolidation can lead to a better credit score

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Historically, Americans lose financial ground and accumulate debt in recessionary environments, and this is already appearing to be happening in mid-2022.

According to a new Forbes pollthe Americans added $266 billion in household debt from the fourth quarter of 2021 to the first quarter of 2022, with two-thirds of consumers saying they are “depleting their savings” as the price of nearly every commodity rises.

This scenario leaves consumers vulnerable to a lower credit score and lower leverage because good credit is hard to come by when a FICO credit score drops below around 660.

This scenario is also a harsh reality, according to Transunion. The credit-reporting company says credit card balances and consumer debt delinquency rates are rising among Americans with credit scores below 660.

“If high inflation persists, the study predicted that delinquencies could reach approximately 8.4% of total credit card loans by the first quarter of 2023, up from 8% in the first quarter of this year, reported Trans Union.

This would lower consumer credit scores even further.

A way to increase credit scores

Consumers looking to reduce personal debt often do so by consolidating multiple sources of debt into one personal loan.

While this can make debt reduction easier, as long as the borrower aggressively repays loan debt, there is also an under-the-radar benefit – it can also boost your credit score.

This sentiment comes from a new study by loan treewhich found that consumers who used a $5,000 personal loan to consolidate credit card debt added an average of 38 points to their credit score during a single billing cycle.

How is it possible?

The study, which followed more than 1,500 anonymous LendingTree users who used a personal loan to consolidate credit card debt, looked at the impact on their credit scores one month after taking out a personal loan to repay credit card debt.

In total, here’s what the study found:

Using a personal loan to pay off credit card debt can dramatically increase your credit score. Consumers who used personal loans to pay off at least $5,000 in credit card debt saw their credit score increase an average of 38 points between the month before the loan was granted and the month after, when it first appeared on their credit report.

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The more credit card debt you pay off with a personal loan, the more your credit score increases. For example, paying off $10,000 or more in credit card debt with a personal loan increased credit scores by an average of 49 points.

Repaying lower amounts can still result in a double-digit increase in credit score. The report found that paying off credit card debt between $1,000 and $5,000 with a personal loan earned borrowers an additional 17 points, on average, in a single billing cycle.

“While it may seem like a bit of stealing from Peter to pay Paul, taking out a personal loan to pay off credit card debt can be a savvy financial decision that pays off in more ways than one,” the report says.

Debt consolidation works up to a point, but it’s not foolproof

Is Lending Tree right? Can credit card consolidation be a good option for cardholders struggling to deal with high-interest credit card debt?

Financial management specialists generally agree, but there are caveats.

“A debt consolidation loan replaces your old debt with a new loan, possibly at a low interest rate,” said Levon Galstyan, a chartered accountant with Oak View Law Group in Glendale, Calif. “If the new loan has a lower interest rate than your credit cards, consolidating your debt is a good decision. This can help you save money on interest, make your payments more reasonable, and minimize the time it takes to pay off your debt.

When a consumer pays off their credit card debt, the credit utilization rate becomes zero, which helps improve their credit rating.

“You pay back the full amount, and that’s a good thing,” Galstyan said. “Potential lenders are impressed. Plus, when you make monthly payments on the new loan on time, it helps establish a positive payment history. This helps improve your credit score.

When consolidating debt through a personal loan, however, consumers need to be extremely diligent for it to work.

“When you take out a personal loan to pay off debt, make sure you’re really making progress,” said Ted Rossman, senior industry analyst at Bankrate.com. “The credit bureaus found that too many people were taking out personal loans to consolidate their credit card debt, but then bumping up their card balances.”

According to other financial experts, the best way to manage debt is to pay it off rather than worry about consolidation.

“The first step to getting out of debt is to lock up all your credit cards and stop going into debt,” said Jay Zigmont, fund manager and founder of Live, Learn, and Plan, a financial advisory firm. based in Mississippi. “It’s very difficult to pay off debt while taking on more.”

After curbing spending, set a specific household debt reduction goal.

“For example, commit to paying off $6,000 in debt over the next year and plan to make one payment each month within your budget (i.e. $500 per month),” Zigmont advised. . “You can follow the ‘snowball method’ (pay the smallest debt first) or the ‘avalanche method’ (pay the highest interest first). But what really matters is that you continue to focus on paying off your debts.

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