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Published:April 30th, 2010 16:34 EST
Credit Card Consolidation: The Good, the Bad, and the Ugly

Credit Card Consolidation: The Good, the Bad, and the Ugly

By Philip Tirone

I often get queries from people wondering about credit card consolidation strategies. Early on in my mortgage business, I assumed (like many people) that consolidating debt onto the card with the lowest interest rate would be a smart move.

But after working in the industry for a decade and studying tens and thousands of credit reports while conducting research for my book, 7 Steps to a 720 Credit Score (Philip Tirone, 2008), I changed my mind about this method of credit card consolidation. No doubt this strategy will save you money in the short term, but in the long run, it could cost you more than it is worth.

 You see, credit-scoring systems place a lot of weight on the debt-to-limit ratio on credit cards. The lower the balance as a percentage of the limit, the better your score will be. Credit-scoring models will respond most favorably to credit cards with a balance that never exceeds 30 percent of the limit. If your limit is $5000, the balance should never be above $1500.

In terms of building credit, this 30-percent-rule applies to each and every card. If you heap all of your debt onto the card with the lowest interest rate, you could very likely exceed the ideal balance of 30 percent or less. This will cause your credit score to drop, which means your interest rates on future loans will increase.

 Of course, if you can keep the balance below 30 percent, this credit card consolidation strategy would be a smart move, saving you money right now and preserving your credit score.

 But in the likely event that the balance would be pushed above 30 percent, you will need to find another credit card consolidation strategy. Here is a credit card consolidation process that has worked for many of my clients:

1. First, call your credit card companies and ask them to lower your interest rates. This will be particularly effective if you are facing bankruptcy or have been late on payments. The facts about bankruptcy are pretty scary. Some estimate that bankruptcy will increase 60 percent by the end of 2010. If your credit card companies fear that you might declare bankruptcy due to your credit card debt, they might jump at the opportunity to lower your interest rates. After all, they would rather get something than nothing.

2. The second part of the credit card consolidation plan is to take a look at the number of credit cards you have. If you do not have between three and five credit cards, you should open some because this will help your credit score. I developed a tool called the credit card score, " which takes a look at whether your credit cards are helping or hurting your credit score. What I found is that the credit-scoring bureaus respond negatively to people with too few credit cards because they do not have enough information to judge their debt-management skills.

If you do not have at least three credit cards, you should open them, being careful to have no more than five credit cards.

3. The final step of the credit card consolidation plan is to place as much debt as you can on the credit card with the lowest interest rate without exceeding the 30 percent rule. Then place as much debt as you can on the credit card with the second lowest interest rate, again being sure not to exceed 30 percent of the limit. Keep spreading your debt among your credit cards in this fashion so that the biggest percentage of debt is on the card with the lowest interest rate, and the lowest percentage of debt is on the card with the highest interest rate.

Of course, this all assumes that you can keep your balances below 30 percent of your credit card limits. If you have a lot of credit card debt, this might be impossible.

Another option is to get a debt consolidation loan, which basically marries several loans into just one loan. In theory, these loans help a person save money and can stave off bankruptcy. When structured correctly, the payment for the debt consolidation loan is less than the combined total of the individual payments.

Debt consolidation loans work like this:

Imagine that you have eight credit cards and one personal loan. Combined, you are payment $1800 a month to these creditors. If you qualified for a debt consolidation loan, the loan would be used to pay the credit card bills and the personal loan in full. You would now have just one loan, with a balance that is the combined total of the credit card bills and personal loan. But now, you pay only $1200 each month.

If you are fortunate, the interest rate is less as well.

In summary, think twice before consolidating all your credit card debt onto the card with the lowest interest rate. Instead, consider other tips on credit card consolidation that won`t hurt your credit score.