Your debt-to-credit ratio weighs heavily on your credit rating at 30% of your FICO score. It is suggested that you keep the amount of open debt owed on each credit card or credit line relatively low, preferably no more than 25% to 50% of the credit limit. For example, it is better to owe $1,000 on three separate credit cards, with each card's limit being $4,000, versus owing $3,000 on one credit card, with a credit limit of $4,000. Spreading the debt over three cards results in a favorable debt-to-credit ratio of only 25%; whereas, owing $3,000 on one card with a $4,000 credit limit unfavorably uses up 75% of that particular credit line. In this case, debt consolidation may not be beneficial.
Perhaps you are considering that you should consolidate your debt by taking a loan at a lower interest rate to pay off several smaller loans at higher interest rates. Making one payment instead of many could make it easier for you to make timely payments, and thus, improve your credit rating over time.
If, for example, you have multiple accounts in default, generally, lenders will consider you a bad credit risk. If you pay the outstanding debts with a consolidation loan, a new credit report should show that you have resolved your debts. Now you have only one active line of credit, being your consolidation loan. Provided you stay current on the consolidation loan payments, your credit rating should be viewed more favorably than before. Payment history accounts for 35% of your credit score. Therefore, you need to pay your bills on time, every time.
Generally, there is no point in consolidating if you cannot lower your interest rate or increase the number of months you have to pay off the debt. The main goal of debt consolidation is to make your payments more affordable. The monthly payment on your consolidation loan should be less than the sum of the monthly payments on your individual debts. If this is not the case, consolidation may not be your best option. Carefully consider the interest rate you pay as well. One downside to debt consolidation is that by extending the time to pay off your debt, you could pay more in interest charges over the life of the loan.
William G. Lako, Jr., CFP®, is a principal at Henssler Financial, and a co-host on Atlanta's longest running, most respected financial talk radio show "Money Talks" airing Sundays at 10 a.m. on Talk 920 AM, WGKA.