Does debt consolidation affect my credit score?

If you are struggling to pay off your debt, you may have already heard about debt consolidation. There’s lots to think about before you start consolidating, and it can get downright confusing once you start thinking about how it may impact your credit score and credit utilisation rate.  

In this guide we’ll run through what debt consolidation is and how to get started. We’ll also explain what a credit score is and what a credit utilisation rate is, and how debt consolidation affects them.

Managing your debt can be stressful, so if you are struggling to create a plan or need a helping hand, you can reach out to one of our friendly team members by calling our Contact Centre on 13 13 86, or by coming into a branch. If you need hardship assistance, you can also check out the guide we prepared on assistance, or complete a hardship form on our website.

What is debt consolidation?

Debt consolidation is a strategy where you turn your multiple small debts, such as credit card debts or personal loans, and instead take out one larger loan. The benefit of this strategy is that you’ll then be left with one repayment rather than juggling multiple different payments, and you may even end up with a better interest rate.

There are multiple ways to consolidate your debt, but usually it involves taking out a personal loan, using a balance transfer on a new credit card, or even refinancing your home or taking out a home equity loan, although this is a riskier option.

Steps to consolidating your debt

Here’s a simple checklist to help you get started with a debt consolidation plan:

1. Check your credit score

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While it can be scary, checking your credit score is important as it gives you a better idea of your financial situation. You can also check your credit report to see which debt or debts are having the biggest effect on your score, so you know to pay those off first.  

2. Organise your debts

The next step is to identify and organise your debts. Make a list of all your debts, and include their sizes, your lender, the amount of interest they are accruing, when their repayments are due. This may also be a good opportunity to create or re-evaluate your budget, as you may identify areas where you can save, giving you more funds to pay off your debts.

3. Create a plan

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Now its time to decide how you want to consolidate your debts, whether its through opening a personal loan, a line of credit, or by accessing your home’s equity through refinancing or an equity home loan.

Depending on the amount you have been approved to borrow or the amount of debts you have, you may not be able to repay all your debts at once. If this is the case, you’ll have to decide which debts you want to pay off first. There are multiple different strategies you can take:

• Snowball method: You can start by paying off the smallest debts, then work your way up to the larger ones. This can help motivate you, as you start seeing results sooner.
• Largest to smallest: This method may work for you if you’ve been approved for enough credit to pay off your largest loans, but is not as common as the snowball method.
• High interest to low interest: Another method is to pay off the loans that are accruing the most interest first, which helps reduce your debts in the long term.

4. Talk to a lender

Once you’ve created a plan, it’s time to approach a lender. Your lender may be able to provide you with more options, or identify weaknesses in your plan, so its definitely worthwhile having a chat to them before opening a loan or line of credit.

What is a credit score?

A credit score is calculated by a credit reporting agency, such as Equifax or Experian, and is normally measured on either a 1000 or 1200-point scale. This score considers how often you’ve applied for credit, your current obligations, and whether you’ve paid your repayments on time.

This score is used by lenders when you apply for credit, and a higher score usually means you are less risky to lend to.

How can debt consolidation help my credit score?

Here are a few ways debt consolidation can improve your credit score, but keep in mind that it may take a few months for your score to improve, so don’t worry if you don’t see changes immediately:

• Reducing the number of debts you have – If you have multiple debts, your score may be impacted negatively as lenders think you are unable to manage your spending. By consolidating your debts into one loan you remove a lot of liability, which makes you a less risky borrower.
• Changing the type of debt you have – The types of debts you have may affect your credit score. Payday loans may hurt your credit score more than taking out a mortgage, for example. Converting your risky debts into a personal loan from a trusted lender may help improve your credit score.
• Reducing your repayments – Missing your repayments can hurt your credit score, and the more repayments you have the likelier you are to miss one. By reducing your debts so you only have one repayment, it becomes much easier to manage and you may be less likely to miss your repayment.

How can debt consolidation hurt my credit score?

While debt consolidation generally helps your credit score, you may see some decreases during this process:

• Applying for more credit – In order to consolidate your debt, you will usually have to open another line of credit or take on another loan, which can temporarily decrease your score. However, your score should start improving once you’ve paid off your other debts, and start making regular repayments on your new line of credit or debt.
• Consolidating through a line of credit or credit card – If you choose to open a new line or credit or credit card to manage your debts, your score may be impacted negatively. This is because these debts are known as revolving debts, meaning you are continuously borrowing from them and they only end when you close your account. Once you start repaying your debt regularly your score will start to improve, but if you start falling behind or missing payments your score may continue to drop.
• Consolidating through refinancing – When you refinance your home you may see a small drop to your credit score, but this is usually reversed once you start repaying your new mortgage on time.

What is a credit utilisation rate and how is it calculated?

A credit utilisation rate (or ratio) is a way of measuring how much credit you use compared to how much you have available. It takes your revolving debts into account, so your credit card debts or other lines of credit, and not your mortgage or personal loan repayments.

Generally, a good credit utilisation rate is 30% or below, which means that you are only using 30% of the credit you have available. To calculate your rate, you can divide your total credit debt by your total limit.   

For example, let’s say you have a balance or debt of $600 on your credit card, and your total limit is $2,000. When we divide $600 by $2,000, we can see that you are only using 30% of your total credit, giving us a credit utilisation rate of 30%.

If you have multiple credit cards or lines of credit, your ratio is normally calculated by totalling all your lines of credit.

If we continue the example above, let’s say you also had another credit card with a limit of $1,000, and a balance or debt of $250. If we add the two cards together, we have a total balance of $850, and a total limit of $3,000. This gives us a rate of about 28%.

However, Experian says that your rate may also be calculated on a per card basis. Using the example above, we would have a rate of 30% on our first card, and a rate of 25% on our second card.  

The lower your rate the better, as it shows that you are able to keep your debts under control, and you are not struggling to meet your repayments. A higher rate may indicate that you are overspending, and lenders may see you as a risky borrower.

How can debt consolidation affect my credit utilisation rate?

Debt consolidation removes some of your liabilities, which helps reduce your limit as you are using less of your total credit. However, your utilisation rate may increase if you close some of your lines of credit. This is because when you close a line of credit, you are reducing your credit limit, meaning you have less credit to use.

This can be confusing, so why don’t we go back to the example we used earlier? We had one credit card with a limit of $2,000 and another card with a limit of $1,000. After consolidating our debts, we may close our card with a balance of $2,000. This means that instead of having a credit limit of $3,000, we only have a limit of $1,000. If we then accrue a balance of $600 on this card, we’ll have a credit utilisation rate of 60%, which isn’t great.

Closing your accounts is generally the norm when consolidating your debt, as you are removing the temptation to use them and overspend again. However, as we saw in our example, reducing our credit limit can negatively impact your utilisation rate if you start accruing high balances.

Whether you leave your credit cards or lines of credit open once they are paid off is ultimately up to you, but if you find that you struggle to pay back credit card debt or tend to overspend, closing them may be the safest option.