Sometimes, trying to address your debt can feel like taking one step forward and two steps back.
Debt consolidation (combining your debts into one) and debt settlement (paying off your debts, typically with a lump sum) are two common approaches to easing your burden, but they come with an unpleasant side effect — your credit score dipping down.
In this article, we promise to take you through a step-by-step guide on how to rebuild credit after debt consolidation. After reading, you should be well equipped to take the first step in rebuilding your credit.
Why Do I Need To Learn How To Rebuild My Credit?
In the U.S., your credit score affects too many areas of your life to simply ignore. When you have a higher credit score, lenders are more likely to approve big loans with low interest rates.
This can help you afford significant purchases such as:
- Business capital
- University tuition
- A car
- A house
These purchases can go a long way towards improving the quality of your life, which can in turn put you in a better place to manage your payments.
On the flip side, a lower credit score will make lenders wary. You won’t have as many options for borrowing and in the event that you do find a lender willing to lend you money, you’ll face higher interest rates. In essence, you’ll have to pay more to borrow the same amount of money.
If you never learn how to rebuild your credit whenever it takes a hit, you risk being in a bad financial position for the rest of your life. You’ll see worse and worse terms whenever you need a loan and your debt will only become more difficult to pay off.
As time goes on, it becomes harder to raise your credit score back up.
How Debt Consolidation Affects Your Credit Score
Debt consolidation works by combining your debts into a single loan, which you then pay off as normal.
This can be helpful for everyone involved — you’ll likely find it easier to deal with a single loan, which means that the lenders can benefit from a greater likelihood that you’ll pay off your debts. That’s great in the long term, but in the short term, it can have a negative impact on your credit score.
This is because longer-standing debts with consistent payment histories are favored by credit bureaus. Also, consolidating your debts into a single account can reduce the amount of total credit available and raise your credit utilization ratio.
It can be frustrating to watch your score go down when you’re actively trying to improve your debt situation, but it’s important to remember that you’ll see improvement later on. Being able to pay off the loan principal faster can keep interest payments lower, which translates into less money spent overall.
Before the long-term effects kick in, however, you can still take some steps to start rebuilding your credit.
How Is My Credit Score Calculated?
Knowing the breakdown of your credit score can help you decide what areas you need to focus on the most.
The three main credit bureaus in the U.S. are TransUnion, Equifax, and Experian. While they all have their own ways of scoring credit, they’re all based on the original FICO system designed in the 1950s.
In the traditional scoring system, your credit is made up of five components:
- 35% Payment History — Any payments you’ve made on your debts. Late payments tend to hurt your score here.
- 30% Credit Utilization — How much of your credit you’re using. It’s best to keep this around 30% (i.e. you only use up 30% of your available credit).
- 15% Length of Credit History — How long you’ve had your accounts.
- 10% New Credit — Recent lines of credit. Helpful for younger consumers fixing their credit scores for the first time.
- 10% Credit Mix — The diversity of your credit accounts. The more diverse, the better, as it shows you can handle different types of loans.
How far down your credit score goes after debt consolidation will vary from person to person. It can depend on factors such as the number of accounts you consolidated, your history on those accounts, how late you were on paying your bills, etc.
How To Rebuild Credit After Debt Consolidation
It can be tempting to run around panicking about your situation, but the first step in this process is to take a step back and survey your situation.
Take a moment to reflect on why you’re in debt in the first place — if any habits or behaviors contributed to your current predicament, you can’t bring them with you on your credit rebuilding journey.
Try to keep these “best practices” in mind:
- Reign in your impulses by setting a timer on major purchases — For example, “I’ll only buy this item if I still want it in three days.” This helps you distinguish between passing wants and persistent needs.
- Discipline yourself by only paying with cash — When paying with credit cards, the loss of money is less visible than handing over a stack of bills. This tends to lead to overspending because you think you have more money than you actually do.
- Question every purchase — Before committing to anything, always review your options. For example, do you really need an $800 phone, or do you just need the basic features that even a $400 phone can provide? This applies to old purchases as well, such as subscription plans. If you haven’t updated them in a while, you might be able to find more affordable plans with the same features.
- Get in the habit of saving — In a 2020 survey by the Bankrate, it was found that around 25% of Americans don’t have an emergency fund. Even if you’re struggling with debt, it’s important to have a bit of cash on hand to handle unforeseen emergencies.
Now that you’ve learned about basic lifestyle changes that can make the process easier, it’s time to start taking actionable steps toward rebuilding your credit score.
1. Keep an Eye on Your Credit Report
As you start rolling your debts into one, you’ll want to monitor your credit report. 30 days after an account should have been closed or frozen, check your report to see if its status was updated properly.
If you don’t see timely updates, try to contact your consolidation loan provider and the credit bureaus. Don’t just assume that your credit report is being updated accurately.
2. Apply for New Credit
If you started with a limited amount of debt and good credit, you may not need to close your existing accounts when consolidating them. In some cases, however, the lender may require you to close all your accounts, leaving you with few to no open accounts to use.
Thus, you may want to get some new credit.
If you’re having a hard time getting approved for a traditional credit card, you can try getting gas cards or store cards. Secured credit cards are also an option.
With a secured credit card, you’ll typically be required to put down a deposit that also serves as your credit limit. Secured credit cards may sometimes come with high fees and interest rates, but they’re still a solid way to start building back a positive credit payment history.
3. Enlist the Help of a Trusted Acquaintance and Become an Authorized User
If you know anyone with a solid credit history, try asking them if they would be willing to add you as an authorized user. Becoming an authorized user of a credit card with a positive, long-established history can be a quick and easy way to inherit good credit history.
Be warned, however, that you should only attempt this with someone you can trust 100%. Both of your actions can affect each other’s credit history, so it pays to be careful.
4. Pay Your Bills in Full — and on Time
The way you pay your bills is actually the biggest factor in determining your credit score.
Sticking to the schedule and paying off the full bill can keep your credit balances low and potentially prevent future credit debt trouble.
5. Consider Getting a Small Loan
Consolidating your debt is great to help you keep up with payments, but credit bureaus still appreciate a diverse credit portfolio. If you already have an existing mortgage or car loan, just keep paying it off as usual.
If you don’t, consider taking out a small installment loan to mix up your credit types. Of course, only consider this if you can afford to pay it back.
If you’re having trouble with finding a lender, credit unions are typically more willing to grant loans to people with “bad” credit than other lenders.
How Long Will It Take To Improve My Credit Score?
The length of time also varies from person to person.
If the accounts you had to close were anomalies in otherwise spotless payment history, your credit score could rebound faster. Having other open credit accounts and other loans (e.g. a mortgage) that you’re paying on time can also help.
However, if you have a thinner credit history or have a ton of derogatory marks on your credit report (e.g. late payments, foreclosures), it will take significantly longer.
Another option that could speed up the process is working with an experienced credit repair firm. They’ll be able to streamline the process for you and identify the areas where change will make the most impact.
It’s impossible to guess how long it’ll take to see improvement in your credit score. It could take less than three years. It could also take the absolute maximum.
Currently, the Fair Credit Reporting Act (FCRA) dictates that the maximum amount of time a derogatory mark can stay on your credit report is seven years. Don’t worry too much about it, though — most cases see improvement within a few years.
In addition, the Comprehensive CREDIT Act aims to bring this seven-year maximum down to four years. It’s still under consideration by the U.S. Senate, but it does bring a spot of hope to anyone struggling with their credit.
Recap: How to Rebuild Credit After Debt Consolidation
The best thing you can do to help your credit bounce back is to pay your bills on time and in full, which accounts for 35% of your score. Also, avoid using up all of your available credit to maintain a good credit utilization ratio.
If you still have open accounts after debt consolidation, continue making timely payments. If you don’t, consider getting new credit or enlisting the help of a trusted acquaintance to become an authorized user.
As long as you don’t incur a large amount of debt again, your credit will climb up to a good level within a few years. A lower credit score isn’t the end of the world — it’s a fixable problem, and can even help you
Take the First Step Today
Trying to repair your credit score can be intimidating, but it becomes easier when you break it down into smaller steps and accept that results will take time.
At 121 Financial Credit Union, we love helping people get on the path to financial success. If you want our help in rebuilding your credit score, all you have to do is reach out! We serve our members at locations all across Northeast Florida and we’d be glad to have you on board.
Alternatively, you can also visit our Financial Learning Center to access a wide range of resources devoted to financial literacy.