If you are like most people, you probably did not set out intentionally to build up a giant pile of credit card debt. Credit card debt tends to sneak up on people little by little, all the more so if you are not monitoring your spending properly. Before you know it your credit card debt can mushroom into an expensive problem which can have a horrible impact upon your credit scores.
Naturally, if you can afford to do so then you should pay off your credit card debt immediately and resolve to keep your balances paid off in full each month moving forward. (You do not need to close your credit card accounts – that could be another credit score damaging mistake – but it is fine to lock those cards away and only use them periodically so that the account does not close due to inactivity.) However, the truth is that most people who are struggling with a large amount of credit card debt cannot simply afford to wipe that debt out by writing a big check.
If you cannot afford to pay off your credit card debt all at once then you can still come up with a debt elimination plan which may ultimately help your credit scores. A balance transfer or a consolidation loan might be an effective part of your plan.
Why Credit Card Debt Hurts Your Credit Scores
Before we cover the 2 different consolidation options previously mentioned and how each one may impact your credit it is important to understand why credit card debt hurts your credit scores in the first place. Credit card debt, unlike other types of debt which may appear on your credit reports, can be harmful to your credit scores even if you make every single payment on time.
FICO’s credit scoring models, the brand most often used by lenders, are designed so that a lot of attention is paid to the credit card debt you carry. More importantly, FICO cares about how your credit card debt relates to your credit card limits. This relationship between balance and limit is known as your revolving utilization ratio. As your revolving utilization ratio climbs your credit scores will begin to take a downward slide.
Balance transfers offer you a way to combine all of your outstanding credit card balances together onto a single credit card account. Typically balance transfer offers boast a low or even 0% introductory interest rate (assuming your credit scores are high enough to qualify) which can potentially save you a lot of money which would be otherwise wasted on high interest fees. A balance transfer fee of 2%-5% or higher is typically charged as well, so be sure to keep that in mind when you are doing the math to make sure that a balance transfer will benefit you financially.
Credit scoring models care about the revolving utilization ratio on each of your credit card accounts individually as well as on all of your accounts combined. When you transfer multiple outstanding credit card balances onto a single credit card account (either new or existing) you can reduce both your number of accounts with balances and also your revolving utilization ratios on a number of different credit cards. Your aggregate revolving utilization ratio may remain roughly the same, but you will likely see at least some credit score benefit by combining multiple outstanding balances into one.
Many banks and credit unions offer personal loans which consumers with good credit can use to pay off expensive, outstanding credit card debt. These consolidation loans are typically installment accounts which are treated much differently than revolving debt by credit scoring models. By using an installment loan to eliminate credit card balances your revolving utilization ratios (both individually and in aggregate) would drop to 0% – a great move from a credit score perspective.
Keep in mind that the interest rates offered on consolidation loans typically cannot compete with the low or perhaps 0% rates you may sometimes receive as part of a balance transfer offer. However, the credit score benefit which accompanies using an installment loan to pay off revolving debt is often significant.
Beware of Temptation
Whether you use a balance transfer or a consolidation loan to pay off your credit card debt you should be cautious with your future spending habits. You will have to discipline yourself not to being charging up credit card debt again after a consolidation or transfer, otherwise you could find yourself in some seriously hot water in the future. Once your credit card accounts are paid off you need to absolutely commit to only charge what you can afford to pay off in full each month moving forward.