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

Guide to Debt Consolidation Loans vs. Personal Loans: Key Differences to Know
Lauren Ward
Lauren WardUpdated May 19, 2022
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Editor’s note: Lantern by SoFi seeks to provide content that is objective, independent and accurate. Writers are separate from our business operation and do not receive direct compensation from advertisers or partners. Read more about our Editorial Guidelines and How We Make Money.
If you have high-interest debt, you may be able to consolidate that debt using either a personal loan or a debt consolidation loan. What’s the difference? 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 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 will work best for you will depend on several factors, including how much you need to cover your debt balances and if you plan to use the funds for purposes 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 off other consumer debts. 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 offer more favorable payment terms than your existing debts, such as a lower interest rate or a lower monthly payment. This can help you pay less in total and potentially get out of debt faster.Over time, debt consolidation can also help you build your credit profile. That’s because adding a new loan will lower your “credit utilization ratio” (the percentage of your available credit you are using) and, as long as you don’t close the old accounts, add to your “credit mix,” both of which can also positively impact your credit. Keep in mind, however, that your credit score might take a dip in the short term. Applying for the new loan typically triggers a credit check known as a hard inquiry, which causes a small, short-term drop in your credit scores. Your scores will likely recover within a few months as long as you keep up with all your bills. Many borrowers find it easier to stay on top of one payment as opposed to multiple bills. 

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 to $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 what the rate and terms will be. Generally, to get a good interest rate, you’ll need good to excellent credit — the higher your credit score, typically the better your rate will be. 

How Personal Loans Work

The way personal loans typically work is that once you are approved, you will 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 off your outstanding debt, as well as other purposes.Keep in mind that some lenders prohibit the use of a personal loan to pay off 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 two to seven years.

What Is a Debt Consolidation Loan?

A debt consolidation loan is a type of personal loan that is designed to be used to pay off existing debts in order to lower a borrower’s interest rate, streamline payments, and otherwise improve loan terms. Debt consolidation loans typically offer 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 will be 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.Like most personal loans, you’ll generally need good to excellent credit to qualify for a debt consolidation loan. Some lenders offer 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 Do 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 would then use the money to pay off your existing debts, such as credit card balances, the remainder of your car loan, the outstanding balance on other personal loans. In some cases, however, the lender will pay off those debts directly, saving you a few steps. Either way, once the debts are cleared, you will start paying off the debt consolidation loan each month according to the terms of that loan.

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 off several debts and streamline your monthly payments into one fixed amount. Both types of loans typically offer 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 will be 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 off those debts. In some cases, the lender will pay off those debts directly.When you borrow money with a personal loan, on the other hand, you will 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 off debt, for personal expenses, or a combination of the two.

Pros and Cons of Debt Consolidation Loans

Debt consolidation loans come with both advantages and disadvantages. On the plus side, a debt consolidation loan allows you to streamline your debt payments and simplify your finances, since you’ll only have one payment to keep track of and budget for. Another advantage is that the lender may pay off your debts for you. You just need to give them your account information and they’ll take care of everything. In addition, your payments may be lower, since debt consolidation loans will typically have a lower interest rate than credit cards. Debt consolidation loans can also help you build your credit profile.On the downside, applying for the new loan can initially hurt your credit scores. 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. Even if each individual payment is lower, you could pay more because there are more of them.

Pros and Cons of Personal Loans

Taking out a personal loan to consolidate debt also comes with pros and cons.  As with a debt consolidation loan, using a personal loan to pay off debts can help simplify bookkeeping, lower your interest rate, and improve your credit profile. 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 some other expenses. Personal loans also typically come with higher limits than debt consolidation loans.Also like debt consolidation loans, applying for a personal loan may initially hurt your credit. Plus, you may get hit with an origination and other initial fees. And, extending your loan term could ultimately lead to higher costs.

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 credit card that offers 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 would not 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.
  • 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 off your debt. This may give you access to lower interest rates, and you will 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.
Recommended: 401(k) Loans vs Personal Loans 

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 are interested in finding out what type of consolidation loan you might qualify for, the first step is to figure out how much you need to pay off your current balances and how much of a monthly payment you can afford. You can then start looking at loan offers that match these terms. With Lantern by SoFi, it’s easy to review and compare personal loan offers from multiple lenders. It only requires one application and checking your rates won’t affect your credit score.*
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Disclaimer: Many factors affect your credit scores and the interest rates you may receive. SoFi is not a Credit Repair Organization as defined under federal or state law, including the Credit Repair Organizations Act. SoFi does not provide “credit repair” services or advice or assistance regarding “rebuilding” or “improving” your credit record, credit history, or credit rating. For details, see the FTC’s website on credit (https://www.consumer.ftc.gov/topics/credit-and-loans)The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.The information and analysis provided through hyperlinks to third-party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.SOLC1221072

Frequently Asked Questions

Can debt consolidation hurt your credit score?
Are debt consolidation loans personal loans?
Why do people consolidate debts?

About the Author

Lauren Ward

Lauren Ward

Lauren Ward is a personal finance expert with nearly a decade of experience writing online content. Her work has appeared on websites such as MSN, Time, and Bankrate. Lauren writes on a variety of personal finance topics for SoFi, including credit and banking.
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