Debt consolidation vs. personal loans: How are they different?
If you have multiple high-interests debts, you may be looking into a personal loan or a debt consolidation loan to repay them
If you have high-interest debt, you may consider consolidating it so that you’ll only have to worry about one monthly payment, and you may save on interest.
While a debt consolidation loan can be a solution, it’s not right for everyone. Here’s everything you need to know about debt consolidation vs. personal loans.
You can learn more about debt consolidation loans and personal loans, and compare rates from multiple lenders with Credible.
- What’s the difference between a personal loan and a debt consolidation loan?
- What are the benefits of a debt consolidation loan?
- What are the disadvantages of a debt consolidation loan?
- When should I not choose a debt consolidation loan?
- Will a debt consolidation loan hurt my credit score?
- How do I qualify for a debt consolidation loan?
- How do I choose the best debt consolidation loan?
- Debt consolidation loan alternatives
What’s the difference between a personal loan and a debt consolidation loan?
Although you might hear or read about debt consolidation loans as if they’re a different product from a personal loan, the two are essentially the same thing. The main difference is that a debt consolidation loan is specifically intended to pay off and consolidate existing debts, while a personal loan can be used for a variety of purposes, including paying for new debt.
Offered by banks, credit unions and online lenders, personal loans are flexible, meaning you can use them for anything you’d like, including paying off high-interest debt. If you take one out, you’ll receive a lump sum of money upfront, ranging from several hundred to tens of thousands of dollars, or even more.
Then, you’ll pay the loan back with interest and fees over an agreed-upon term. Factors like your credit score and income will determine whether you get approved and the rate a lender offers you. Since most personal loans are unsecured, you won’t have to put your house, car or another asset on the line.
Debt consolidation loans
A debt consolidation loan is a personal loan used to combine multiple debts into a single loan, ideally with an interest rate that’s lower than the rates you’re paying on the debt you want to consolidate.
Here’s how it works: You’ll apply for a personal loan for the amount that you owe on your existing debts. Once you’re approved, you’ll use the funds to pay off your debt. Then, you’ll eventually pay off the new loan over the agreed-on repayment term.
Debt consolidations loans tend to be unsecured and can go up to tens of thousands of dollars or more.
What are the benefits of a debt consolidation loan?
A debt consolidation loan comes with several benefits and can be a good idea if you have multiple high-interest debts, such as credit card balances.
- Lower interest rate — If you qualify for a lower rate than what you’re currently paying on your debts, you can save thousands of dollars in interest.
- Easier debt payoff — By combining several debts into a single loan, you’ll reduce the number of payments you’ll have to make every month and simplify the payoff process.
- Can improve credit — A debt consolidation loan can reduce your credit utilization ratio (how much of your available credit you’re using) and increase your credit score.
- May decrease monthly payments — If you spread out your payments over a new, longer loan term, you can lower your monthly payments and free up cash each month.
What are the disadvantages of a debt consolidation loan?
A debt consolidation loan also comes with some potential drawbacks, including:
- Not a solution to your financial problems — If overspending contributed to your original debt, a debt consolidation loan doesn’t guarantee that you’ll never go into debt again.
- Upfront fees — Depending on the lender you choose, you may be on the hook for upfront fees, like loan origination fees and prepayment penalty fees if you pay off the loan early.
- Potential for a higher rate — Unless your credit is in stellar shape, there’s a chance you’ll have to settle for a higher interest rate than you’d like. Still, your new personal loan rate may be lower than a credit card interest rate.
- Missing payments can lead to further issues — If you miss payments on your debt consolidation loan, you may have to pay late fees and non-sufficient funds fees that will increase your cost of borrowing. And, missed or late payments can affect your credit score.
When should I not choose a debt consolidation loan?
A debt consolidation loan isn’t always a good idea. If you don’t have a lot of high-interest debts or the budget to make your monthly payments on time, it can do more harm than good. Also, if you can’t secure a loan with a lower rate than what you’re currently paying, it might not make sense.
In addition, a debt consolidation loan won’t be beneficial if you have poor spending habits and aren’t able or willing to change them. If you rack up more debt on the cards you pay off, for example, your financial situation may become even worse.
Will a debt consolidation loan hurt my credit score?
While a debt consolidation loan can improve your credit in the long run, it may also hurt it temporarily. When you apply for any new credit, the lender will likely perform a hard inquiry, which can reduce your credit score by a few points.
Since opening a new account like a personal loan can temporarily lower your credit score, you may also notice an additional dip when you take out a debt consolidation loan.
The good news is that making your payments on time can help your credit score recover and ultimately improve. Additionally, a debt consolidation loan will lower your credit utilization ratio and may improve your credit as well.
How do I qualify for a debt consolidation loan?
Every lender has its own unique requirements for borrowers interested in debt consolidation loans. But most lenders will look at factors like your credit score, income and debt-to-income ratio as indications of how likely you are to repay your loan.
While lenders generally prefer borrowers with good to excellent credit, debt consolidation loans for bad credit do exist. Just keep in mind that these loans usually come with higher interest rates that can increase the overall cost of your loan. If you have bad credit or fair credit, you might also have to apply with a cosigner or put up collateral.
How do I choose the best debt consolidation loan?
Not all debt consolidation loans are created equal. That’s why it’s important to shop around to find the right option for your unique situation. When you do so, consider these factors.
- Interest rate — The lower interest rate you can lock in, the better. If you have a good credit score, you may qualify for a very good rate that saves you a lot of money in the long run.
- Loan amounts — Some lenders offer higher loan amounts than others. Figure out how much you need to borrow to pay off your debts and look for lenders that may be able to lend you that amount. Avoid the temptation to borrow more than you need.
- Repayment terms — If lower monthly payments are your goal, longer repayment terms are your best bet, but you could end up paying more in interest over the life of the loan. On the flip side, if you’d like to pay off your debt as soon as possible and save on interest, look for shorter repayment terms. A shorter term will reduce total interest costs but may mean a bigger monthly payment.
- Fees — Some lenders charge fees like origination fees, late fees and prepayment penalty fees. Make sure you know how much they’ll cost you before you sign on the dotted line.
- Collateral — While most debt consolidation loans are unsecured and don’t require collateral, there are secured loans that do. If you’re eligible for an unsecured loan, you won’t have to risk your property or vehicle as collateral. But if you’re looking for a debt consolidation loan with bad credit, you may need to secure it with collateral.
If the lenders you find allow you to, you may want to prequalify for debt consolidation loans. This can make it easier for you to compare your options without taking a toll on your credit.
Debt consolidation loan alternatives
If you decide that debt consolidation loans aren’t right for you, here are some other ways to manage your debts:
- Debt snowball method — The debt snowball method is a DIY debt-relief strategy that has you pay off your smallest debt first and then apply the payments you were making toward it to pay the next-smallest debt. You continue this cycle and build momentum, or "snowball," your payments until you’re debt-free.
- Debt avalanche method — While the debt avalanche method is also a DIY strategy, it focuses on saving money in interest over time. With the debt avalanche, you pay down your debt with the highest interest rate first and then move on to the debt with the next-highest interest rate.
- Balance transfer credit card — With a balance transfer credit card, you can transfer high-interest credit card debt to a card with a 0% interest rate for a limited time, as long as you pay a transfer fee. Once the introductory period ends, you’ll have to pay off the remaining balance with the card’s standard interest rate, which might be high. Be aware, though, you generally need good to excellent credit to qualify for a 0% card.
- Home equity line of credit (HELOC) — A HELOC allows you to borrow money against the equity in your home. Just like a credit card, you can borrow as much or as little money as you’d like up to a set limit and put it toward your debt. But this method puts your home at risk since it secures the HELOC.
- Cash-out refinance — A cash-out refinance replaces your current mortgage with a new one that’s larger than your outstanding balance. You can take out the difference and use it to consolidate debt. Again, tapping your home equity to consolidate debt turns unsecured debt into one that’s secured by your home. Consider all the pros and cons before taking this route.
- Debt settlement — Debt settlement is when you or a company negotiate with your lenders and creditors to pay less than what you owe. If you go this route, your credit score will likely drop.
- Credit counseling — With credit counseling, you work with a credit counselor to create a debt management plan, or DMP. The DMP can reduce your credit card interest rates, but may also adversely affect your credit.
- Bankruptcy — Bankruptcy involves going to federal court so that your debts can either be discharged or reorganized. Since it can take years for your credit to recover after bankruptcy, it should be a last resort for debt relief.
Comparison shopping with Credible can help you find a debt consolidation loan that’s right for you.