In this article:
Personal loans can be used for any purpose, but a popular (and often prudent) use for them is paying off high-interest debt, in which case they are considered debt consolidation loans.
What is the Difference Between a Personal Loan and a Debt Consolidation Loan?
Practically, there is no difference between a personal loan and a debt consolidation loan. Debt consolidation is just one of many uses for a personal loan.
A personal loan is a form of installment credit that can be used for anything you choose. Common uses (aside from debt consolidation, which we'll discuss below) include funding weddings, honeymoons or dream vacations; paying medical expenses; and covering the costs of home or auto repairs. Usually there are no restrictions on how you use a personal loan.
Amounts typically range from $1,000 to $20,000, but personal loans as large as $100,000 can be had from several lenders. Personal loans are a form of unsecured credit: Unlike secured loans, such as mortgages and auto loans, they don't use any property as collateral that the lender can seize and sell if you fail to repay the loan. When you're approved for a personal loan, you typically receive the borrowed sum as a check or direct deposit to your checking account. The money is yours to spend as you see fit, and your first installment payment is typically due one month later.
Debt Consolidation Loan
A debt consolidation loan is simply a personal loan used for reorganizing other debts. While lenders sometimes tout the benefits of debt consolidation when marketing personal loans, there's no special category of loan known as a debt consolidation loan. Your decision to use a personal loan to pay off other debts makes it a debt consolidation loan.
To do so, you use the sum you borrow to pay off one or more other debts—credit card balances, the remainder of your car loan, the outstanding balance on other personal loans, and so on. "Consolidation" refers to the strategy of replacing several separate monthly loan payments with just one bill.
When to Use a Personal Loan
Because you can use a personal loan for just about anything, it's easy to think up reasons to get one—but that doesn't mean you should. Personal loans can be lifesavers when you need cash to pay for emergencies, such as a dead furnace or a ruptured appendix. If you take out a loan for something more frivolous, you may not qualify for (or be able to afford) a second loan when disaster strikes.
With that in mind, if your emergency fund and retirement savings are in good shape and your monthly expenses are manageable, funding a once-in-a-lifetime vacation or the bicycle of your dreams, for instance, could be a good use for a personal loan.
Benefits of a Debt Consolidation Loan
For many borrowers, the convenience of replacing multiple bills with a single monthly payment is reason enough to consider a debt consolidation loan. In contrast to the changing balances and minimum payment amounts on credit card bills, a personal loan's fixed payment amount can also simplify budgeting.
The biggest benefit of a debt consolidation loan, however, is the amount of money you can save on interest charges. The national average interest rate for credit cards is about 16%, and the average rate on a 24-month personal loan is about 10%.
As with other types of credit, the interest rates you're charged on a personal loan vary according to your credit score. Borrowers with FICO® Scores☉ in the very good (740-799) and exceptional (800-850) ranges can expect to get the best deals on personal loans and credit cards alike.
How Will a Personal Loan Affect Your Credit Score?
Still another benefit of debt consolidation is the potential for boosting your credit scores. Using your personal loan to pay off credit cards lowers your credit utilization ratio—the percentage of your credit card borrowing limit represented by your outstanding credit card balances. If your utilization on any single credit card or your overall utilization among all cards exceeds 30%, your credit scores can suffer—so paying off your card balances can help your score improve.
Adding a personal loan to your portfolio of credit accounts can also increase your "credit mix," or the different types of credit you manage. Credit mix can also promote a higher credit score.
On the downside, applying for a personal loan typically triggers a credit check known as a hard inquiry, which causes a small, short-term drop in your credit scores. Your scores typically will recover within a few months as long as you keep up with all your bills.
If mishandled, a personal loan can also have a more serious negative effect on your credit score. Missing just one payment on any loan is the single event that can do the most damage to your credit score. So when considering a personal loan for debt consolidation or any other purpose, take care to ensure you can afford the monthly payments.
If you use a loan for debt consolidation, resist the temptation to run up new balances on the credit cards you paid off with the loan. Managing new card charges along with the monthly installments on the personal loan could blow your budget and undo the credit score benefits of lowering your utilization rate—not to mention defeating the original purpose for the loan.
Alternatives to a Debt Consolidation Loan
Debt consolidation loans aren't the only way to manage your debts. Here are two other options to consider:
- Balance transfer credit cards: While the interest rates on personal loans can be considerably lower than those on credit cards, the introductory rates on many new credit cards is even lower: 0%. Transferring the balances from other cards to a new card with a 0% interest rate can save you money, but be careful: You're typically charged a fee on each transfer that is a percentage of the transfer amount (usually about 3%). Also, those low intro rates are typically good for 21 months or less, after which any unpaid portion of the transfer amount is subject to the card's standard interest rate. Do the math to confirm that the transfer fee will cost you less than you'd pay in interest on the original charge. If so, and if you can pay off the transferred amount in full before the intro rate expires, you could save some money and boost your overall spending limit as well.
- Debt management: Debt consolidation is a good strategy for organizing and reducing the costs of credit card bills and other personal debt, but it may not be enough if your debt is out of control. If you're feeling overwhelmed by your bills and have missed or are about to miss bill payments, it's worth seeking help. Credit counseling can help you get a handle on your finances and explore your options for getting debt under control, and a debt settlement program can help you negotiate with your creditors to lower your monthly expenses and eventually get you out of debt. These programs can have negative consequences for your credit scores, but they can also ease your stress and put you in a good position to rebuild your credit.
The flexibility and versatility of personal loans make them useful for a host of potential purposes, and one of the best ways you can use them is as a debt consolidation tool to reduce the hassle and high cost of managing multiple credit card bills and other high interest debt.