Why Debt Consolidation Loans Don’t Work
Before the collapse of the housing market, consolidating debt through the use of home equity loans was a popular solution to the debt problem. However, this type of debt solution doesn’t help when it comes to qualifying for new credit and here’s why: your debt-to-income ratio remains the same, or higher. Additionally, assuming you have the discipline not to use those credit cards while you’re repaying your consolidation loan, you now have revolving accounts that are left idle. And without continual repayment on different types of credit, it’s difficult to rebuild positive credit history.
Credit scores are determined not only by your payments, but also by the amount of credit you have versus the amount you use. Credit scores are also partially determined by your “mix” of credit. You want to have active credit card accounts, and installment payment accounts such as a car loan or mortgage. If you cancel your credit cards in an attempt to keep your debt-to-income ratio at the same levels, then you’ve eliminated a third factor in your credit scoring – length of time for active accounts.
So what can you do instead of debt consolidation? The standard advice tends to be the best advice – start with a credit card that has the highest interest rate and pay it down first. Conversely, if you have credit cards that have a very small balance, pay those off first and then work towards paying off the ones with higher interest. If you work your way through your credit card debts systematically, you can make a difference in your credit scores.
The absolute worst thing you can do is get a debt consolidation loan and then max out the cards you just paid – not only does that leave you in a worse position financially, but it also makes it extremely difficult to qualify for credit in the future, as these types of actions are seen as high-risk by creditors. If you have a debt consolidation loan in progress, keeping your credit cards active by using them for a nominal purchase ($50 or less) may help you to lessen the potentially negative impact on your credit score. Keep in mind that you should only use the cards if you know you can pay them back in full – use them to purchase items that you would normally pay for in cash or check, and then use those funds to pay off the credit card instead.
Once you have your balances lowered, you want to keep them that way – try not to charge more than 10% – 30% of your available balance each month, and pay it off month to month. You don’t have to carry a balance in order to show a positive credit history, but you do need to have consistent charges that get paid on a monthly basis. If you’re really set on a debt consolidation loan, avoid using one that will tie up your home equity. Instead, get a personal loan through your bank or credit union, and use it to cover the amount of your high interest rate credit cards. In this way, you can continue to make payments on the lower interest cards, and maintain the balance of your credit mix.
