Debt consolidation might hurt your credit — here's how to avoid the damage

Debt consolidation can be an excellent solution if you have multiple debts you're struggling to keep up with. It makes getting out of debt easier — and sometimes cheaper.

That said, debt consolidation isn't a magic bullet. It can temporarily ding your credit score or bring even more damage if you're not disciplined with your debt repayment. Below, CNBC Select discusses what debt consolidation can do for your wallet and your credit, plus how to get the most out of it.

The idea behind debt consolidation is simple. You take multiple unsecured debts and combine them into one, ideally with a lower interest rate. The most common ways to do that include a debt consolidation loan and a balance transfer card.

With a debt consolidation loan, you apply for a specific amount of money to cover your total debt. If the lender approves you, it will usually pay your creditors directly or deposit the funds into your bank account. Once you've eliminated your debts, you'll just have one loan to pay with fixed monthly payments.

If your credit is in good shape despite your debt load, look into lenders such as LightStream. We ranked this lender as providing the best debt consolidation loan for people with good-to-excellent credit because it offers a low interest rate and same-day funding. Plus, you don't have to pay any origination, early payoff or late fees.

Successfully applying for a debt consolidation loan when you have a lower credit score may be a challenge, but you still have plenty of options. CNBC Select ranked Achieve as the best lender for those with less-than-ideal scores — you can qualify with a credit score of at least 620 and check whether you're likely to be approved before you apply.

Consolidating your debts with a balance transfer credit card works similarly to a loan. If you carry a balance on one or more credit cards, you can move that debt to a balance transfer card with an intro 0% APR offer, usually for a fee of between 3% and 5% of the transaction amount. This will allow you to pay the balance without interest charges for a specified period. For example, the Wells Fargo Reflect® Card offers a 0% intro APR for 21 months from account opening on purchases and qualifying balance transfers (17.74%, 24.24%, or 28.49% variable APR thereafter). Balance transfers made within 120 days qualify for the intro rate, BT fee of 5%, min: $5.

If you do it right, debt consolidation might slightly decrease your score temporarily. The drop will come from a hard inquiry that appears on your credit reports every time you apply for credit. But, according to Experian, the decrease is normally less than 5 points and your score should rebound within a few months.

Then, as you keep paying off your debt, your credit should go up since you'll be improving your credit utilization ratio, or how much of your available credit you're using. The lower this ratio is, the better — anything over 30% can damage your credit. Credit utilization has a huge effect on your credit score (second only to payment history), so keeping it low should give your score a big boost.

Don't become your own worst enemy

When you combine your debts into one, you'll likely find it easier to manage your repayments, especially if the interest rate of this new loan is lower than the rates on your original loans. This is especially true if the interest rate on the new loan is lower than your original interest rates, or if you're using a balance transfer card. Naturally, you might feel tempted to continue using your credit cards now that your debt seems less of a worry.

But that would set you up for a world of hurt. If you keep adding to your debt, you may find it has become hard to stay on top of your payments again. Slipping and missing even a single payment can cause significant damage to your credit. Further, late payments stay on your credit reports for seven years. As a result, you risk ending up with even more debt — and a lower score.

Debt consolidation can be a good strategy but it requires some discipline to work. Here's how to avoid digging yourself deeper into debt during the consolidation process:

• Know your budget and stick to it. This is especially important if your new interest rate is higher, meaning you'll pay more in interest charges. Make sure you're not taking on a loan you realistically can't afford.
• Avoid taking on new debt. Focus on paying down your current debt without adding to it. If you continue charging your credit cards, you might swipe yourself into a new pile of debt.
• Shop around for a lender. Compare different offers to find the lender that can provide you with the best terms, such as lower interest and no prepayment penalties in case you can pay off the loan before the term's end.
• Set up autopay. This feature will help you avoid late payments. Plus, some lenders offer discounts for enrolling.

At CNBC Select, our mission is to provide our readers with high-quality service journalism and comprehensive consumer advice so they can make informed decisions with their money. Every credit guide is based on rigorous reporting by our team of expert writers and editors with extensive knowledge of credit products. While CNBC Select earns a commission from affiliate partners on many offers and links, we create all our content without input from our commercial team or any outside third parties, and we pride ourselves on our journalistic standards and ethics.

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