Credit utilization is important, as it constitutes about a third of your overall credit score
Once you combine all your credit card balances into the new debt consolidation loan, all these cards will be at zero balance. This is a key step on your way to becoming debt free. Credit cards with low or no balances on them are also good for your credit rating, since they improve your overall credit utilization.
Credit utilization, meaning the amount of available credit a person has borrowed, is one of the five factors used to compute your overall credit score. Therefore, when you consolidate all your debt into the new loan, thereby leaving your old credit cards with no balances, this could immediately help to improve your credit.
Ensure you keep those credit cards open after transferring the balances to your debt consolidation loan, however. Closing out the cards decreases the overall credit you have available and will affect your credit utilization factor. While this seems counterintuitive, closing out those old cards in an attempt to manage debt will actually harm your overall credit score. However, be sure to put those cards away or cut up the plastic, because using them after you’ve consolidated your debt will also affect your credit utilization rate.
Budgeting Your Way to Better Credit
One of the reasons people are saddled with so much debt, and the average to poor credit that goes along with it, is because they fail to plan. Most Americans don’t have any sort of budget whatsoever; a staggering 70% of us don’t even have $1,000 in the bank to cover unexpected expenses. If you’re one of the people who manage finances by the seat of your pants, debt consolidation might help you manage your money more deliberately and improve your credit at the same time.
When you consolidate all your debts, you’ll only have to deal with a single payment to the lender each month. This will put your debts back into proportion with the rest of your bills. It should also make it much easier to make a monthly budget, since you can now precisely track your debt expenses. A budget can help you stay on top of your bills each month and decrease the chance of a missed payment. It’ll also help you focus on chipping away at the balance you owe on your outstanding debts. As your budget helps you establish a consistent payment history and pay down your outstanding debt balance, your credit will gradually improve, too.
However, your budget will only help your credit and debt situation if you follow it. Many people prepare a budget and start with the best intentions, only to ignore their plan when it comes time to make snap purchasing decisions. Other people don’t adjust their budget based on the reality of the situation and fail to account for decreases in salary or unexpectedly higher monthly expenses. As a result, they end up saddled with more debt and a lower credit rating than when they started. So, stick to the plan if you want to succeed!
Indirect Benefits
A few of the more unique debt consolidation loan options have characteristics that can indirectly improve your credit rating. A home equity line of credit (HELOC) provides a good example of this. If you consolidate debts with a HELOC, you may be able to claim the interest you pay on the loan on your Federal income taxes. The tax savings realized from this can be applied toward the principal on your loan, which will reduce your outstanding debt and help to improve your credit.
If you take out a loan from your 401(k) retirement plan to consolidate your debts, credit-reporting agencies won’t consider that a traditional debt, such as a loan from a bank. You’ll therefore be able to consolidate all your credit cards without, at least in the eyes of the credit-reporting agencies, taking on additional debt. This will allow you to streamline your debt repayment efforts without any significant impact to your credit rating.