Guide to Debt Consolidation Loans vs Personal Loans: Key Differences to Know

If you have high-interest debt, you may be able to consolidate that debt using either a personal loan or a debt consolidation loan. 

A debt consolidation loan is a type of personal loan that is used specifically to repay other lenders and combine high-interest debt into one lower-cost balance. A personal loan, on the other hand, can be used for consolidating debt, as well as for other purposes, such as paying for a large purchase or covering an emergency expense. 

Which type of consolidation loan works best for you will depend on several factors, including how much you need to cover your debt balances and whether you plan to use the funds for other than just paying down debt. Here’s what you need to know when comparing personal loans vs. debt consolidation loans.

What Is Debt Consolidation?

Debt consolidation is when you take out a new loan to pay down other consumer debts. Then, instead of making payments each month on several credit cards or other loans, you only make a single payment. 

The point of getting a loan for debt consolidation is that it can provide more favorable payment terms than your existing debts, such as a lower interest rate or a lower monthly payment. This may help you pay less in total and potentially get out of debt faster.

What Is a Personal Loan?

A personal loan is a type of installment loan (meaning it’s a set amount of money that gets paid back over a set period of time) that can be used for almost any personal expense, such as a home renovation, a vacation, medical expenses, or debt consolidation. You can get personal loans from banks, credit unions, and online lenders in amounts ranging from $1,000-$100,000 (or more), depending on the lender and your qualifications as a borrower. 

In most cases, personal loans are unsecured, which means you don’t have to put up an asset, such as a car or home, as collateral for the loan. A lender will instead look at your credit, income, and debt-to-income ratio to determine whether you qualify for a personal loan, as well as what the rate and terms will be. Generally, to get a good interest rate, you’ll need good to excellent credit. Typically, the higher your credit score, the better your rate. 

How Personal Loans Work

The way personal loans work is that once you are approved, you receive the loan amount (principal) in one lump sum as a check or direct deposit to your checking or savings account. You can then use the money to pay down your outstanding debt or for other purposes.

Keep in mind that many lenders prohibit the use of a personal loan to pay down student debt, so if that’s your intention, you’ll want to make sure it’s allowed by the lender before you apply.

Your first installment payment (which will include both principal and interest) is typically due one month after you receive the funds. The repayment period, known as the loan term, can be anywhere from one to seven years.

Recommended: Guide to Payday Loan Consolidation

What Is a Debt Consolidation Loan?

A debt consolidation loan is a type of personal loan that is designed to be used to pay down existing debts in order to lower a borrower’s interest rate, streamline payments, and otherwise improve loan terms. Debt consolidation loans typically have lower interest rates than most credit cards, depending on your credit score, and allow you to budget for a single, predictable monthly payment. 

Like other personal loans, debt consolidation loans are typically installment loans, which means you’ll pay the loan back (plus interest) via fixed monthly payments over a set period of time. Unlike general personal loans, the loan amount you can get is based on your current debt balances, and some lenders cap the amount at $50,000 or less. Debt consolidation loans typically have repayment terms of one to five years.

You’ll generally need good to excellent credit to qualify for a debt consolidation loan. Some lenders have debt consolidation loans for borrowers with low credit scores, but interest rates will likely be higher. 

Debt consolidation loans are available through banks, credit unions, and online lenders.

How Debt Consolidation Loans Work

Once you’re approved for a debt consolidation loan, you may receive the funds in a lump sum via a check or direct deposit. You could then use the money to pay down your existing debts, such as credit card balances, the remainder of your car loan, or the outstanding balance on other personal loans.

In some cases, however, the lender will pay down those debts directly, saving you a few steps. Either way, once the preexisting debts are reduced or cleared, you start paying down the debt consolidation loan each month according to the terms of that loan.

Recommended: Guide to Debt Consolidation Loans for Veterans

Debt Consolidation vs Personal Loans

Personal loans can be used for almost any purpose, while debt consolidation loans are designed to be used to pay down several debts and streamline your monthly payments into one fixed amount. Both types of loans typically have lower interest rates compared to credit cards. So, which should you use, and what’s the difference?

The main difference between personal loans and debt consolidation loans is the purpose of the loan: whether it’s used for personal expenses or for debt consolidation. With a debt consolidation loan, the loan amount is based on the existing loan balances you’re looking to consolidate, and the funds you receive from the loan need to be used for paying down those debts. In some cases, the lender may pay down those debts directly.

When you borrow money with a personal loan, on the other hand, you receive it in one lump sum, either via check or direct deposit. You can then decide how you want to use that money — whether that’s to pay down debt, for personal expenses, or for a combination of the two.

Pros and Cons of Debt Consolidation Loans

Pros of Debt Consolidation Loans

On the plus side, a debt consolidation loan allows you to streamline your debt payments and simplify your finances, since you only have one payment to keep track of and budget for. 

Another advantage is that the lender may pay down your debts for you. If you give them your account information, they can take care of everything. 

In addition, your payments may be lower, since debt consolidation loans typically have a lower interest rate than credit cards. Debt consolidation loans can also help you build your credit profile.

Cons of Debt Consolidation Loans

On the downside, applying for a debt consolidation loan can hurt your credit score if payments are missed or not made on time. In addition, these loans sometimes come with some hefty upfront costs, such as origination fees or balance transfer fees, which could reduce or wipe out the savings on interest. 

Also, keep in mind that debt consolidation loans can typically only be used to cover your debt, and amounts may be limited. If the loan isn’t large enough, you may still have some debt payments to make. 

Finally, if you opt for a longer loan term, you could end up paying more for your debt over the life of the loan.

Recommended: How Does Debt Consolidation Affect Your Credit Score?

Pros and Cons of Personal Loans

Pros of Personal Loans

As with a debt consolidation loan, using a personal loan to pay down debts can help simplify bookkeeping, lower your interest rate, and build your credit profile. Most personal loans also come with a fixed interest rate, so you pay the same amount each month.

Unlike a debt consolidation loan, a personal loan can be used for any purpose, which could be helpful if you want to use the loan to not only consolidate debt but also cover additional expenses. 

Cons of Personal Loans

Also like a debt consolidation loan, applying for a personal loan may initially hurt your credit. You may get hit with an origination and other initial fees. Extending your loan term could also ultimately lead to higher costs. And, of course, there’s always the temptation to spend your loan.

Alternative Forms of Debt Refinancing

Taking out a personal or debt consolidation loan is one way to consolidate debt, but it’s not the only one. Here are some other options.

• Balance transfer credit cards: You may be able to get a balance transfer credit card that has a 0% annual percentage rate (APR) for up to 21 months, which could be useful for consolidating smaller debt. If you are able to pay the new card off within the introductory period, you won’t have to pay any interest on that debt. If you don’t pay the full balance off during that time, however, you could potentially end up with a higher rate than you are currently paying. Also, be aware of balance transfer fees that could potentially eat up your savings on interest.

• Home equity line of credit (HELOC): If you’re a homeowner and have equity in your home, you might be able to use a HELOC to consolidate your debt. Because a HELOC is secured by your home, you might get a lower rate compared to a personal loan or debt consolidation loan. However, there is risk involved: You could lose your home if you end up not being able to make the payments.

• 401(k) loans: You may be able to take a loan from your employer-sponsored retirement account to pay down your debt. This may give you access to lower interest rates, and you pay the interest to yourself. However, not all 401(k) plans allow loans, and if you don’t repay the loan on time, you can get hit with taxes and high fees.

The Takeaway

Both personal loans and debt consolidation loans can be used to consolidate debt, lower your monthly payments, and streamline your finances. The main difference between these two lending options is that debt consolidation loans are designed specifically for consolidating debt, whereas personal loans can be used for a wide variety of purposes.

If you’re interested in consolidating your debt, consider Lantern by SoFi. With Lantern, it’s easy to review and compare personal loan options from multiple lenders. It only requires one application and there’s no obligation to you.

Find personal loan options with Lantern.