A debt consolidation loan is a type of loan, which can be either a personal loan or a business loan. Most personal loans can be used for several potential purposes. However, if you have mountains of debt, whether it’s credit cards, medical bills, or something else, then debt consolidation loans are particularly useful for simplifying repayment.
Key Takeaways
- Personal loans are usually unsecured installment loans. Debt consolidation loans are a type of loan, which can be either personal or business, that you can use to combine multiple outstanding balances into one.
- You can use debt consolidation loans for most kinds of debt, including credit cards, outstanding medical bills, and car repairs.
- If you need to borrow money for a purpose other than debt consolidation, you can take out a different type of personal loan.
Personal Loans
A personal loan is an installment loan that can be used to fund almost anything, including home repair costs, a wedding, adoption fees, paying back taxes, and more.
You’ll receive all of the loan’s funds in a lump-sum payment, and then you repay the loan over time in monthly installments until it’s repaid in full. Most personal loans are unsecured, which means interest rates are based on a borrower’s credit score and credit history, and you likely won’t need collateral to secure the loan.
Pros
Wide range of borrowing and repayment options
No collateral required for most types of personal loans
Interest rates are usually fixed, so monthly payments are predictable
Cons
No standard eligibility requirements; every lender and loan type is different
A high credit score is usually needed to secure the lowest interest rates
Different minimum loan amounts mean you may end up with more funds than you need
Debt Consolidation Loan
A debt consolidation loan is a type of loan that’s used to consolidate debt. Many debt consolidation loans are advertised as such—a borrower can typically use one to consolidate any kind of debt they have to streamline payments and save on interest in the long run.
A debt consolidation loan allows you to borrow an amount of money equal to the total of your outstanding loans to pay off all that debt at once. You then make one payment on your new loan each month, which has its own interest rate and repayment terms, typically lower than your existing APRs.
Although a debt consolidation loan makes it easier to handle payments by consolidating them into one, they may or may not save you money. If you sign up for an exceptionally long repayment term, you may owe just as much interest over time. Do the math to figure out how much it will cost over the life of the loan.
Pros
Streamlines outstanding debt into a single monthly payment
You’ll pay less interest over the life of the consolidated loan compared to having to repay several simultaneously, each with their own interest rate
Using a consolidation loan to pay off outstanding credit cards can free up your available credit
Cons
The hard inquiry from completing a loan application temporarily hurts your credit score
Loan approval depends on your credit score, income, debt-to-income (DTI) ratio, and more
Taking out a new loan decreases your average age of credit, which also impacts your credit score
Personal Loan vs. Debt Consolidation Loan: Which One to Choose?
Remember that debt consolidation loans can be either personal loans or business loans. Unless you’re taking out a debt consolidation loan out on behalf of a business, any debt consolidation loans that you apply for will likely be personal loans. As such, which one you ought to choose should be based on what you need the loan for.
You’ll want to get a debt consolidation loan if you:
- Have a lot of outstanding loans or credit cards with high interest rates, which are costing you more time and money in the long run
- Can find an interest rate for a debt consolidation loan that’s lower than the interest rates of the debt you’re repaying right now
- Have a few different outstanding loans and want to streamline your payments into a single monthly payment
A different kind of personal loan might make more sense if you need funding for any number of potential purposes, such as an emergency home repair, fixing your car, a down payment on a wedding venue, or something else. If your credit is good enough and you can make all the payments, you can even have several personal loans at once.
Although it's important to shop around for the best interest rate when comparing loan offers, be sure to compare theannual percentage rate (APR), which represents the total loan cost, including both interest and fees.
How Do I Qualify for a Debt Consolidation Loan?
For individual borrowers, a debt consolidation loan will typically take the form of an unsecured personal loan. This means that your credit score and history, debt-to-income (DTI) ratio, and employment status are used to determine your eligibility. How much you need to borrow and the expected repayment terms can also factor into your eligibility.
Can I Get a Debt Consolidation Loan if I Have Bad Credit?
Every lender has different eligibility requirements, but typically, the higher your credit score, the more likely you are to qualify for the lowest interest rate offered. A low credit score doesn’t mean your loan application will be rejected, but you’re more likely to have a higher interest rate on your loan.
Do Debt Consolidation Loans Affect Your Credit Score?
When you complete a loan application, a hard inquiry occurs as a result of the lender pulling your credit report to check your credit score and credit history. This, along with the new loan reducing the average age of your credit history, will cause your credit score to temporarily decrease. However, in most cases, your score will rebound after a few months of on-time payments. Your score will likely fall further if you make late payments or miss them entirely.
How Long Does Debt Consolidation Stay on Your Record?
Your debt consolidation loan stays on your credit report for as long as the account is open. Missed payments or accounts that go into delinquency or default, in addition to debt settlement agreements, can stay on your credit report for seven years or up to however long it takes to settle your outstanding debt.
How People Use Personal Loans?
Investopedia commissioned a national survey of 962 U.S. adults between Aug. 14, 2023, to Sept. 15, 2023, who had taken out a personal loan to learn how they used their loan proceeds and how they might use future personal loans. Debt consolidation was the most common reason people borrowed money, followed by home improvement and other large expenditures.
The Bottom Line
Using a debt consolidation loan to pay off outstanding loans can be a smart way to reduce how much interest you would otherwise pay in the long run, in addition to making payments easier to manage. If you need money for more than just debt consolidation, you can use a personal loan to fund those needs.
Each lender has different eligibility requirements, so make sure to compare your options before submitting an application for either type of loan.
