Personal loan vs. debt consolidation

Personal loan basics

A personal loan is an unsecured installment loan that can be used for just about any purpose and ranges between $1,000 and $100,000. Loans are often offered for between 24 and 60 months, but some lenders may have longer terms.

“Typical personal loans feature fixed interest rates, repayment periods from two to seven years, and loan amounts from a few to tens of thousands of dollars.

“The loan approval process and rates will depend on the borrower’s credit score, income, and debt-to-income ratio,” said Elliot Schwartz, finance expert and CEO of credit-boosting program, Becca’s. “Loans typically come with fixed monthly payments, and most will charge some fee …”

A few lenders charge origination fees, which can be as high as 10% or more of the loan amount, but many lenders don’t charge these fees. Interest rates will also vary by lender, but will likely be between 6.99% and 35.99% APR, depending on your creditworthiness.

Borrowers often take out personal loans to make large purchases, take a vacation, cover medical bills or pay for car repairs. Lenders typically have restrictions that don’t allow borrowers to use loans for activities such as investing or gambling.

To qualify for a personal loan, you’ll want to have at least fair to good credit, which starts at 580, although the exact score required may vary by lender. A credit score in the 700s will usually get you favorable interest rates. You’ll also want to have a debt-to-income ratio of 35% or lower; again, this can vary by lender.

When you are approved for the loan, the entire loan amount is disbursed to you, and you’ll begin making monthly payments.

» COMPARE: Top personal loan companies

Debt consolidation basics

Debt consolidation is when you take out a loan and use the funds to pay off existing debts. For example, let’s say you have the following debts that total $16,500 and have $438 in minimum monthly payments:

• Credit card 1: $7,000 at 18% APR and $175 minimum monthly payment
• Credit card 2: $4,500 at 18% APR and $113 minimum monthly payment
• Medical bill: $5,000 with $150 monthly payment

Debt consolidation can lower your monthly payment and simplify your finances. If you take out a debt consolidation loan for $16,500 at 8% APR for five years and use it to pay off these existing debts, your new monthly payment would be about $330.

Debt consolidation loans have similar eligibility requirements to personal loans. You’ll want to have a credit score of at least 580 and a debt-to-income ratio of 35% or lower. And like personal loans, you may see origination fees, 6.99% to 35% APR, late fees, and more.

When you apply for a debt consolidation loan, you’ll typically include the lender names and account numbers for the debt you plan to pay off. If the lender approves your application and amount, it’ll pay off your debt directly and you’ll begin making payments on your new debt consolidation loan instead.

Compare personal loans and debt consolidation

Debt consolidation loans can only be used to pay off existing debts. Personal loans, on the other hand, can be used for just about anything, including debt consolidation.

Personal loan pros and cons

Personal loans are great for accessing funding you otherwise wouldn’t have to pay for large expenses. Here are personal loan pros and cons to understand how they can help but also hurt your bottom line.

» DIVE IN: Pros and cons of personal loans

Debt consolidation pros and cons

Debt consolidation loans can be a critical tool for reducing your debt and getting your personal finances back on track. Although they’re great for improving your financial health, you should know the advantages and drawbacks associated with them.

Impact on credit scores

Both personal loans and debt consolidation will affect your credit. Whether that impact is good or bad will depend on how you handle the loan repayment and manage new credit.

Personal loans

Personal loans can increase your debt-to-income ratio, which can impact your creditworthiness and make it harder to get a loan in the future — at least until the personal loan is paid off.

It can also lower your score by causing a hard pull on your credit when you apply, and a new loan will lower the average age of your accounts. Of course, missing any loan payments can negatively impact your credit score, too.

However, personal loans may improve your credit if you make all your payments on time. It’s also an installment loan, which can improve your credit mix, especially if you only have credit card accounts on your credit reports.

Debt consolidation

With debt consolidation, you may see a drop in your credit score at first. “Initially, when a borrower applies for a loan, they may see a small dip in their score due to the hard inquiry on their report,” Schwartz explained. There may also be changes in your credit utilization or account age, especially if you close existing credit cards that have now been paid off.

Debt consolidation can improve your score over time as long as you stay current with payments on the new loan. If you don’t close the paid-off credit cards, it can also improve your credit utilization ratio, resulting in a higher credit score.

» LEARN MORE: Debt consolidation pros and cons

Choosing the right option for you

Personal loans can be used for almost any purpose, including debt consolidation. Debt consolidation loans can only be used to consolidate debt, and the lender will pay your old creditors directly.

You may want to consider other options for managing your debts, including paying them off using the debt snowball method. With this method, you make the minimum payment on all debts, except for the debt with the lowest balance. You then pay off that one debt as quickly as possible by making the largest payment you can. When that debt is paid off, you move on to the next. Continue this method until all debts are paid off.

Other alternatives include balance transfer cards, home equity lines of credit (HELOC) and home equity loans (HELOAN).

Balance transfer credit cards often offer 0% APR for an introductory period, allowing you to transfer your credit card balances to the new card and make payments with no interest during the intro offer period.

HELOCs and HELOANs typically have lower APRs than personal or debt consolidation loans and allow you to draw on the equity you’ve built in your home. Because their draw periods are typically longer than personal loans, you may have longer to pay off the balance.