How Does Debt Consolidation Affect Your Credit?

The Impact of Debt Consolidation on Your Credit Score

“The only way to permanently fix your credit is to change your spending behaviors.” – Suze Orman

When in the throes of overwhelming debt, one may feel like they’re fighting a losing battle. However, a lifeline exists in the form of debt consolidation. The question that remains though, is “How Does Debt Consolidation Affect Your Credit?” This article takes a deep dive into understanding the effect of debt consolidation on your credit score.

The Debt Conundrum in Canada

In the third quarter of 2020, the household debt ratio in Canada rose to a staggering 170.7%. This figure represents the ratio of debt owed to the disposable income available in households. This alarming trend presents a clear need for effective debt relief systems. Debt consolidation is one such solution, but the effect it has on one’s credit score is often a source of concern for many Canadians.

Demystifying Debt Consolidation

Debt consolidation is a process that entails combining multiple smaller debts into a single debt or payment, sometimes referred to as “debt refinancing”. The primary aim of this process is to alleviate the burden of high-interest debts by consolidating them at a lower interest rate, thereby inhibiting the rapid growth of the debt.

There are two prevalent forms of debt consolidation:

1. Debt Consolidation Loans

Debt consolidation loans are essentially loans offered by lenders, such as banks, to consolidate multiple smaller debts into one single loan. Here, the bank provides the client with a loan large enough to pay off all their outstanding debts to their creditors. However, the debt is not eliminated, rather it is transferred to a single lender as opposed to multiple creditors.

The terms of a consolidation loan are largely determined by the applicant’s credit score. Therefore, a person with a good credit score is likely to secure a loan with a lower monthly interest rate. However, individuals with low credit scores may face difficulties in securing these loans or may be given loans with extremely high-interest rates, which could lead to more harm than good.

2. Debt Consolidation Programs

An alternative to debt consolidation loans is Debt Consolidation Programs (DCPs). These programs combine various unsecured debts into a single monthly payment, which is processed through a service offered by a non-profit credit counselling agency. Unlike consolidation loans, DCPs don’t shift your debts to another form of debt, but rather you pay down the total amount of your unsecured debts until they are completely paid off.

DCPs do come with certain restrictions, such as the requirement to stop using all forms of unsecured credit. However, you can still obtain a secured credit card while on a DCP.

The Role of a Secured Credit Card in a Debt Consolidation Program

A secured credit card can be an invaluable tool while on a DCP. It can be used in emergencies, for renting a vehicle or a hotel room, and it can also help build your credit. The card company may require a security deposit, which acts as collateral in case you fail to make payments. However, the creditor will not use your security deposit as “payment” on the card. You must make your own payments on a secured credit card.

Debt Consolidation Loan and Its Impact on Your Credit

Applying for a debt consolidation loan can influence your credit in several ways:

  1. Creation of a “Hard Inquiry” Against Your Credit. When you apply for a loan, the lender conducts a “hard inquiry” to assess your credit score and rating. This can temporarily lower your credit score.
  2. Inclusion of a New Credit Line Item on Your Credit Report. The debt consolidation loan appears as a new line item on your credit report, which could potentially lower your credit temporarily. However, as the new credit item ages and you make consistent payments, this could eventually improve your credit score.
  3. Improved Credit Utilization Rate. The loan pays off all your debts, which could improve your credit utilization rate. This can help boost your credit score, provided you don’t accumulate more debt.

In the short term, debt consolidation loans can slightly lower your credit score. However, with consistent payments and a strong payment history, you can gradually improve your credit score.

Debt Consolidation Program and Its Impact on Your Credit

A DCP will also impact your credit score. However, since most individuals who sign up for a DCP already have bruised credit, this is not a significant concern. When you sign up for a DCP, your debts will have an R7 rating, and then two years after completion, these debts, along with their R7 ratings, will be purged from your credit reports.

Can You Consolidate Your Debt with Bad Credit?

Consolidating credit card debt with bad credit can be challenging. If your credit score is low, your application for a debt consolidation loan may be denied, or you may be offered unfavorable terms on the loan. However, there are debt consolidation options for bad credit scores, such as DCPs offered by a non-profit credit counselling agency.

Beware of Debt Consolidation Scams

Before you jump on board with debt consolidation, it’s crucial to be aware of potential scams. Unscrupulous individuals may offer quick fixes that promise to erase your debt overnight or fix your credit score instantly. Beware of credit repair scams and loan scams that may take advantage of your vulnerability.

Is Debt Consolidation a Good Idea?

Debt consolidation can be a viable solution if you partner with a reputable lender or non-profit organization. The benefits of debt consolidation, such as reduced interest rates and a single monthly payment, can significantly outweigh the risk of a temporary drop in your credit score.

Wrapping Up

Dealing with credit card debt can be daunting, but with the right approach and a trusted credit counselling agency, it is possible to successfully navigate this journey.

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