Does Debt Consolidation Hurt Your Credit? A Complete Guide

Excessive personal debt can be scary for people to deal with—especially when you feel like you’re on your own. There are different debt solutions to consider, like debt consolidation, and one of the big questions many Canadians have is how debt consolidation can affect their credit.

Canadians often have a lot of questions about debt, and it’s no wonder, especially when you consider that the household debt ratio (the ratio of debt owed versus how much disposable income households have) in Canada rose to 176.4% as of Q1 2024. The good news is there are different debt relief options available.

In a struggling economy, nobody wants to pay more for services simply because of a bad credit score. So, it’s only natural to have questions about how different debt relief options, like debt consolidation loans, can affect your credit score.

What is debt consolidation? What are different debt consolidation options? Can you consolidate credit card debt with bad credit? Let’s find out!

What is Debt Consolidation?

Debt consolidation is a practice where several smaller debts are combined (i.e., “consolidated”) into a single debt or payment. This can sometimes be referred to as “debt refinancing.”

In some cases, high-interest debt can be consolidated at a lower interest rate—making it easier to pay off since the debt won’t grow as quickly. Here’s a table breaking down the various types of debt consolidation:

Common Forms of Debt Consolidation

Here’s a closer look at the types of debt consolidation:

1. Debt Consolidation Loans

Debt consolidation loans are offered by lenders (such as a bank) to combine several smaller debts under a single loan. In basic terms, the bank extends the client a loan large enough to pay off their outstanding debts to their creditors.

The goal of a consolidation loan is to reduce the average interest rate of all the debts that are being paid off with the loan and amortize the total debt load over a longer period. The purpose of a debt consolidation loan is to reduce the strain of the overall debt load on personal finances. The debt does not go away—it’s just owed to a single lender instead of a variety of different credit card companies, banks, and other businesses.

The terms of a consolidation loan, including consolidation loans used to consolidate credit card debt, are largely determined by the applicant’s credit score. Someone with a good credit score will be able to get a loan with a lower monthly interest rate compared to someone with a lower credit score. Unfortunately, many people who need debt consolidation loans often have a low credit score and either cannot get a loan or they get one with an extremely high interest rate (which may require a co-signer to back the loan). Debt consolidation loans for bad credit do exist, but they typically have less-than-favourable terms compared to ones offered to people with stronger credit. In many cases, these high-interest rate loans cause more harm than good.

Additionally, these loans can make it look like the borrower has a lot of room on their credit cards, which can be tempting to use. It’s important to exercise strict discipline on credit card spending once you obtain a debt consolidation loan. Otherwise, you could end up back at square one with your debt, plus have this giant new loan to pay off as well. Some lenders require that you close your credit cards or reduce the maximum limit to avoid charging up the credit cards again.  If you know you’re not going to be able to manage your spending, this is a good practice to follow to avoid increasing your overall debt load.

There are several alternatives to debt consolidation, including:

• Home Equity Loans: Use your home as collateral.
• Home Equity Line of Credit (HELOC): Works like a credit card with a revolving balance.
• Balance Transfer Credit Cards: Allows you to transfer credit card balances to a high-limit card.

Richard Haggins, Sr. Education Facilitator at Credit Canada says debt consolidation can be a useful method for clearing debt problems if the following conditions are met:

• There needs to be significant interest savings with the consolidation loan.
• The borrower must resolve to avoid running up the cleared credit cards.
• The borrower must make a serious effort to pay down the loan as soon as possible. Ideally, the borrower should continue making the same dollar amount payments as pre-consolidation to maximize the benefit of lower interest rates.

2. Debt Consolidation Programs

Debt Consolidation Programs (DCPs) are an alternative to debt consolidation loans where several forms of unsecured debts — including credit card debt, payday loans and outstanding bills — are combined into a single monthly payment. This payment is processed through a debt consolidation service or program offered by a non-profit credit counselling agency, like Credit Canada.

DCPs are sometimes referred to as debt management plans (DMPs) or debt consolidation plans since they are virtually identical.

Under a DCP or Debt Consolidation Program, the debt relief provider consolidates a person’s unsecured debts into a single monthly payment. They’ll also negotiate with creditors to stop or significantly reduce the interest charged on the debts. This helps to make it easier to pay down the debt itself (the principal) instead of paying more towards interest.

Under a DCP, your debts aren’t shifted to another form of debt, as is the case with a debt consolidation loan. Instead, you pay down the total amount of your unsecured debts on the Program with every single monthly payment you make until they are completely paid off. DCPs create breathing room and provide a simplified plan to pay off your debts in a reasonable manner, so you can still take care of your monthly expenses. DCPs are a great alternative for anyone who cannot obtain a debt consolidation loan, has poor credit, or is unable to find a loan with a favourable interest rate.

DCPs do come with some restrictions. For example, you will be required to stop using all forms of unsecured credit, including credit cards; however, this isn’t usually a big deal for most people who sign up for a DCP because they are often maxed out anyway. Plus, when you sign up for a DCP, you still have the option of getting a secured credit card.

Struggling with debt? Our certified Credit Counsellors will work with you to find the best debt relief solution for you. Learn more about our Debt Consolidation Program.

Having a secured credit card while on a Debt Consolidation Program

Secured credit cards are very helpful in emergencies, when renting a vehicle or hotel room, and they can also help build your credit.

A credit card company may ask you for a security deposit in order to be approved for one of their secured credit cards. The deposit required may not match the credit limit offered. For example, the required security deposit may be $75 but the limit on the card may be $500.

The security deposit is a form of collateral in case you don’t make payments; however, the creditor will not use your security deposit as “payment” on the card. You must make your own payments on a secured credit card. Ideally, you will pay off the entire balance before the statement due date; however, you are permitted to carry a balance on a secured credit card. Having said that, this should not be your intention. You want to avoid carrying a balance and charge only items that you can afford to repay.

Does Consolidating Debt Affect Credit?

In short, yes. Debt consolidation can affect your credit.

Debt consolidation is often misunderstood as a quick fix for financial troubles. Many believe it will automatically improve their credit score when, in fact, the initial hard inquiry and potential for increased debt can temporarily lower it. Others think it reduces the total debt owed, but it merely combines multiple debts into one payment, often extending the repayment period.

Additionally, debt consolidation can increase the total interest that must be paid during the life of the loan and high interest rates from loans or credit cards can make the situation worse.

How Will a Debt Consolidation Loan Impact My Credit?

Let’s look at a few potential credit-related benefits and drawbacks of a debt consolidation loan.

Pros

There are three main benefits associated with debt consolidation loans:

• Improved credit utilization rate. By using a debt consolidation loan to pay off your existing credit card debts, you reduce the balances on those cards to zero, lowering your credit utilization rate.
• Potential for improved payment history. With only a single monthly loan payment (usually lower than pre-consolidated payments combined), you’ll be more likely to stick to your payments.
• Simplified debt management. You’ll only need to focus on one goal (paying off your loan) with a single payment and unified interest rate.

A consolidation loan isn’t a quick fix, however. It can have serious implications on your credit score as shown below.

Cons

A debt consolidation loan also presents certain risks, including:

• A new hard inquiry: The lender will run your credit, dropping your score slightly in the short term.
• A new credit line: Your report will contain a new line item, which may temporarily lower your score. Other debts on your credit report paid off by the debt consolidation loan will be up to date, however, and this can slowly improve your credit rating.
• More debt: Your credit cards will be paid off, but that could create a temptation to use them and drive balances right back up.

Be mindful of these drawbacks, as they may make it harder to escape the debt cycle. 

Can I Consolidate My Debt with Bad Credit?

Consolidating credit card debt if you have bad credit can be a bit difficult. If you have bad credit and apply for a debt consolidation loan, you may end up getting denied for the loan or get offered unfavourable terms on the loan that limit the benefits of applying for one in the first place. Worse yet, the lender’s check of your credit can lower your credit score a bit further, making future attempts to qualify for a loan even less fruitful.

Debt consolidation options for bad credit scores are available though.

Take, for example, Debt Consolidation Programs (DCPs) offered by a non-profit credit counselling agency, like Credit Canada. DCPs are available even with extremely low credit scores, making them a viable option for debt consolidation with bad credit.

Unsure about how to tackle your debt? Find out the best way to manage your debt with our Free Debt Assessment Quiz now!

How to Maintain a Healthy Credit Score During and After Debt Consolidation

Here are a few ways to maintain a good score during and after consolidation:

• Make required payments on time.
• Keep your card balances low.
• Avoid opening new accounts.
• Limit new inquiries.

Cumulatively, these tactics will help you maintain and even improve your score. 

Debt Consolidation Scams to Look Out For

Before searching the web for “debt consolidation loan for very bad credit” or “guaranteed debt consolidation loans,” it’s important to be aware of debt consolidation scams that some Canadians may fall prey to.

Many unscrupulous individuals may try to take advantage of Canadians living with debt (or in the process of recovering from debt) by offering them so-called easy solutions that “fix” their credit score or get rid of their debt overnight. If you hear about a “fast” fix for debt or credit, be sure to approach it with a healthy amount of skepticism. There is no such thing as an easy credit fix or solution that magically makes your debt disappear without any drawbacks. 

Two examples of debt-related scams that Canadians should watch out for include:

• Credit Repair Scams. Credit repair scams prey on people who need to improve their credit fast. Whether you’re trying to buff up your credit to apply for a consolidation loan, business loan or mortgage, these scammers will try to take advantage of you. Warning signs include:
• Offering to remove bad information from your credit history (unless the information is inaccurate, they cannot do this, and if it is inaccurate, you can remove it yourself at no cost);
• Making instant approvals with no credit checks (meaning they don’t have the information they will need to actually help you);
• Requesting upfront fees;
• Asking for unusual forms of payment (such as gift cards); and
• Advising that you shouldn’t reach out to a credit bureau (who may warn you about the scammer).
• Loan Scams. Some scammers may pose as legitimate lenders who offer unsecured debt consolidation loans for people with bad credit. These individuals are often looking to steal your money—taking your consolidated loan payments without actually paying out your creditors. Some warning signs of a loan consolidation scam include:
• Requiring large “upfront” payments, even if they’re just “processing fees” to start the process (it’s illegal to request a payment when no contract has been signed);
• Unsolicited “pre-approved” loan offers (real lenders don’t just call people to congratulate them on being approved for a loan—so this should be an immediate red flag);
• Lots of complaints or no presence online (check the Better Business Bureau’s Scam Tracker or Google Review pages to see what people are saying, if anything, about the lender); and
• Incomplete contracts or no contracts at all (scammers don’t like leaving paper trails and may use contracts that have blanks they can easily fill or simply provide no paperwork at all).

Is Consolidating Debt a Good Idea?

With all of the above in mind, you may be asking yourself, “Is consolidating my debt a good idea?” The answer is that it can be.

When you partner with a reputable lender or non-profit organization like Credit Canada, debt consolidation loans and programs can offer significant benefits that well outweigh the risk of a temporary drop in your credit score. Some things to look for in a reputable Debt Consolidation Program or debt consolidation lender include:

• Unbiased debt advice. How much the people offering the Program or loan know about personal finance and their ability to provide clear direction that’s easy to understand and follow.
• Their understanding of your situation. Anyone can fall into debt, whether due to a job loss, illness or some other unexpected life event. Having a partner on your side who completely understands how you got to this point can help immensely in addressing your debt concerns, and in so doing, help you become debt-free forever. 
• How reasonable the program/loan is. To pay off your debt successfully, the interest rate on your new loan needs to be less than what you’re currently paying on your individual debts, including any fees. If you go the Debt Consolidation Program route, you should be paying an affordable monthly payment and saving a significant amount in interest charges. 

Don’t navigate debt alone. Our credit counselling service provides expert guidance from certified Credit Counsellors to help you get on top of your finances. Get help with your debt today!

Alternatives to Debt Consolidation

Here are a few alternatives to debt consolidation:

• Negotiate directly with creditors.
• Transfer balances to a low-interest credit card.
• File for bankruptcy as a last resort.

A DCP provider like Credit Canada handles many of these tasks while saving you the hassle of negotiating with creditors. Our Credit Counsellors will also assess your situation by completing a detailed financial assessment.Other solutions will be suggested if one is better suited for your situation.  And best of all, the assessment is FREE!

How to Pay Off Credit Card Debt

Do you need help addressing rising debt, like credit card debt? Regardless of how you decide to handle your debt, having a trusted, experienced, unbiased, and reliable certified Credit Counsellor on your side can help. As a non-profit credit counselling agency, all of our counselling services are free at Credit Canada, and you can meet with your Credit Counsellor as many times as you need to. Contact us to get a free debt assessment and to understand your debt consolidation options and start consolidating your debt today. Call 1.800.267.2272 or click here to learn more.