Personal Loans vs. Debt Consolidation
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At a Glance
Personal loans can be used for a variety of reasons, including consolidating debt, while debt consolidation loans can only be used for debt consolidation. While they are similar, there are a few crucial differences, as well as advantages and disadvantages depending on your financial situation.
In this article, learn more about:
Difference between personal loans vs. debt consolidation
When it comes to personal loans vs. debt consolidation loans, they are the same thing. The biggest difference is that personal loans can be used for funding about anything, while debt consolidation loans are specifically intended for consolidating and paying off existing debt.
Personal loans are offered by banks, credit unions, and online lenders. The funds can be used for about anything, including home renovations, car repairs, medical bills, funding a vacation or wedding, large emergency expenses, and others.
When you are approved for a personal loan, you will receive a lump sum of money, typically ranging from $1,000 to $100,000. Then, you will make fixed payments each month to repay the loan. These payments will include interest and fees, or APR, over the loan’s term.
Most personal loans are unsecure, meaning you don’t have to use any assets as collateral to get approved. However, you are more likely to get better loan terms and interest rates if you have an excellent credit score.
Learn more: What is a Personal Loan?
Advantages of personal loans
- Funds can be used for about anything.
- Lower, fixed interest rates make budgeting easier.
- Have a definitive end date when the loan will be paid off.
- Loan approval and fund transfer can happen quickly, even within one business day.
- Can pre-qualify for the loan online and get an estimate of loan terms and interest rates prior to applying.
Related: Benefits of Obtaining a Personal Loan
Disadvantages of personal loans
- Interest rates will be high for borrowers with poor credit.
- Often have fees, such as origination fees, service fees, and others.
- If you do have a secure personal loan, meaning you must have collateral to qualify, you could lose that asset if you do not repay the loan.
Related: Pros and Cons of Personal Loans
Debt consolidation loans
Debt consolidation loans are a type of personal loan but are solely used to consolidate debt. When you consolidate debt, you are combining multiple debts into one loan, ideally with a lower interest rate. This makes managing your debt payments easier and can help you pay off the loan faster and save money in the long run.
If you need a debt consolidation loan, you’ll apply for a personal loan in the amount you owe on your existing debts. Once you are approved, you will use those funds to pay off all your debt. Then, you will make payments toward your new loan, and pay it off over the term.
Advantages of debt consolidation loans
- Often have lower interest rates, so you will pay less than what you are currently paying in interest on existing debt which can help save you money.
- Reducing the number of payments, you are making each month to one payment makes paying off the debt easier and more manageable.
- Debt consolidation loans can help decrease your credit utilization ratio, which may increase your credit score.
- The new debt consolidation loan term may be longer than your other debt, which can lower your monthly payments.
Disadvantages of debt consolidation loans
- Some lenders may charge fees such as origination fees, prepayment penalties, and others.
- May have higher interest rates depending on your credit score, so it is important to shop around for a rate that is lower than your current debt.
- Missing payments can lead to paying fees and decrease in your credit score.
- While debt consolidations can help you get out of debt, they are not a solution to the problem. It is important to understand how you got into debt in the first place and plan to avoid going into debt again.
Related: Pros and Cons of Debt Consolidation
How to choose between a personal loan and a debt consolidation loan?
If you do not have debts to consolidate, there is no reason to get a debt consolidation loan. Or, if you have multiple debts but they are not high interest debts, or if you do not have the budget to make the monthly payments on time, a debt consolidation loan may not be the best option.
Additionally, if you are not willing or able to change your spending habits to avoid going back into debt, getting a debt consolidation won’t help and could decrease your credit score if you do not make the payments.
If you need funds for wedding, vacation, medical bills, or other reasons, choose a personal loan. These loans are flexible with how you can spend the funds, can vary in the total amount, and may have lower interest rates if you have excellent credit.
Alternatives to debt consolidation loans
Debt consolidation loans are not the only way to pay off your debts. Other ways include:
1. DIY repayment methods, such as the debt snowball method or debt avalanche method. With the snowball method, you pay off your smallest debt first, then your next smallest, and so on until your debts are paid off. The avalanche method has you pay off the debt with the highest interest rate first, then the next highest, and so on. With both methods, you continue to make the minimum payments on all debts.
2. HEL or HELOCs can be an option if you own your home. Home equity loans and home equity lines of credit are lending options that allow you to borrow against your home’s equity. These often have longer repayment periods and lower interest rates, but you can lose your home if you do not make the payments.
Learn more: Home Equity Loans vs. HELOC
3. Balance transfer credit cards allow you to transfer credit card debt from multiple cards onto one. These cards typically have a 0% introductory APR, which gives you time to pay off the debt before interest starts to accrue.
Learn more: Balance Transfer Credit Cards
4. Debt settlement, which is when you negotiate with the lender to pay a lower amount than what you owe to satisfy the debt. You can do this yourself, or work with a debt settlement company or lawyer. However, to do this, you must stop making minimum monthly payments, which can lead to late fees, interest, and damage to your credit score.
Learn more: How Debt Settlement Works
5. Credit counseling, which is working with a credit counselor or counseling agency to create a debt management plan, which can reduce your interest rates, but can also negatively affect your credit.
6. Filing for bankruptcy, which should be your last option, but involves filing with the federal court so your debts can either be completely discharged or reorganized so you can pay them off more easily. This can drastically decrease your credit score and can be challenging to recover from.
Related: What Is Bankruptcy and How to Avoid It
Other options can include a 401(k) loan, payday loan, peer-to-peer loan, personal line of credit, or family and friends.
Personal loans can be used to consolidate and pay off debt, which can be beneficial. However, personal loans are a type of debt, and missing or making overdue payments can significantly decrease your credit score.
Related: Personal Loan for Debt Consolidation
When you first apply for a loan, it triggers a hard credit inquiry, which can temporarily decrease your credit score. However, making your payments on time can help your credit score improve because it shows you are a responsible borrower. Plus, a debt consolidation loan can lower your credit utilization ratio, which can increase your score.
Debt consolidation loans can be either secured or unsecured, though most are unsecured. This means you do not need to provide assets as collateral, and you will not lose your assets if you don’t pay the loan back.