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A Guide to Personal Debt Consolidation Loans

What Are Personal Debt Consolidation Loans?
Sheryl Nance-Nash

Sheryl Nance-Nash

Updated January 12, 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.
Personal debt can be a result of many of life’s complications. For any number of reasons, you may find yourself in a position where you are unable to pay off a credit card purchase when the bill arrives, and you carry over the balance to the point that it becomes burdensome. Or it could be that you have gotten behind on medical or utility bills. When this happens, you may be looking for a strategy to manage your debt. A personal debt consolidation loan is a financial tool that might work for you. 

What Are Debt Consolidation Loans?

When your debts have high interest rates, it can be beneficial to consider what debt consolidation is and what it might accomplish in your financial life.At its most basic, it’s a personal loan. The loan proceeds are used to pay off other debts. Ideally, a personal loan for debt consolidation has a lower interest rate than the debts it's paying off. Using a personal loan to consolidate credit card debt is a common strategy. The average credit card interest rate is just over 16% as of December 22, 2021. If you qualify for a personal loan rate that’s lower than your credit card interest rates, you may be able to save money on interest over the long term.Paying off debt with personal loans can also mean having a fixed interest rate instead of a variable rate, if the other debts are set up that way. Not only can this decrease the amount of interest being paid, it can simplify your monthly payments. Instead of making multiple payments to multiple lenders, you’re making just one payment to one lender. 

How Do Personal Loans for Debt Consolidation Work?  

Starting the process by adding up your current debts is a good first step. A personal loan for debt consolidation is meant to be used to pay off other debts and help your financial situation, not add to your debt load. So it’s a good idea to borrow just the amount needed to accomplish that. After loan approval, the loan proceeds are distributed in one lump sum. Some lenders will deposit the money into your account, after which you can pay off the debts yourself. Other lenders may pay those creditors directly, saving you that step.From that point, you will be responsible for the monthly payment on the new personal loan.

Pros and Cons of Debt Consolidation Loans 

Any type of debt can be beneficial or have drawbacks, depending on the borrower’s financial situation and how they manage their debt. A personal loan for debt consolidation is no different. 

Pros

Capitalizing on Fixed Rates

There’s something to be said for certainty. Many personal loans have fixed interest rates — they remain the same over the term of the loan. If the rate on your personal loan for debt consolidation is lower than the interest rates on the debts you’re consolidating, it’s likely you’ll save money on interest charges in the long term. 

Improving Your Credit Score

Any inquiry into your credit report may affect your credit score. But not all inquiries are equal.A soft inquiry done at the prequalification stage typically will not affect your credit score. A hard inquiry, which a lender will do at the time of application will likely affect your credit score by dropping it a few points.In the long term, however, consolidating high-interest debts with a lower-interest loan may improve your credit score if you make regular, timely loan payments.

Simplifying Payments

It can be easy to overlook a bill, miss a payment, and owe interest and late charges, which will ultimately increase your debt and negatively affect your credit.But with just one monthly payment on a personal loan for debt consolidation vs. multiple payments to multiple lenders, monthly bill paying can be much simpler. 

Potentially Low Interest Rates

Credit cards typically have high interest rates, and you may be able to qualify for a personal loan for debt consolidation that has a lower interest rate than you’re paying on your credit cards.  Locking in a lower interest rate over the term of a personal loan can mean significant savings overall.

Cons

Some Lenders Charge Fees

Any fee a lender charges on a loan will be included in the loan agreement. Reading and understanding what you’re agreeing to is important before you sign it. Not all lenders charge fees, so it’s a good idea to compare lenders before you choose one. Some common fees are origination fees, which can be between 1% and 6% of the total loan amount, late fees, prepayment penalties, and other charges. 

It’s Still Debt

Consolidating debt doesn’t erase that debt — you still owe what you owe. It’s a smart financial tool for some people — not all personal loans are bad — but is most successful when no other debt is accumulated along with it. Changing spending habits and figuring out why you were in debt in the first place is just as important as paying down the debt. 

Debt Consolidation May Not be Right for Everyone

One common goal of debt consolidation is to qualify for a lower interest rate than the rate you’re currently paying. But what if your credit isn’t good enough to qualify for a lower rate? One option may be to look into how to get a debt consolidation loan with bad credit. Some lenders will work with you so you can get the most favorable terms possible with your credit score.But you may also opt for a different strategy than debt consolidation. Some people successfully pay off their debt using the debt snowball or debt avalanche strategies.

When Can Debt Consolidation Be a Good Idea?  

A personal loan for debt consolidation debt has its benefits, but is getting one right for you? 
  • You’re likely a good candidate if you can consistently make timely payments. Late and missed payments could mean fees and other charges added to your loan balance. 
  • If you qualify for a lower interest rate than those on the debts you plan to consolidate, then it might be worth looking into how to get a debt consolidation loan. 
  • If you feel overwhelmed by the number of monthly payments you’re making, consolidating those debts into one new loan may lessen that mental burden and help you feel more organized. 

Can Any Debt Be Consolidated?

Not all debts are candidates for consolidation. Typically, unsecured debt like credit card debt or medical bills can be consolidated with a personal loan. But it’s not usually an option for car loans or mortgages, which are secured debt. Federal student loans cannot be consolidated with a personal loan, but there are other options for managing federal student loan debt without forfeiting federal loan benefits. 

Will Debt Consolidation Affect Your Credit Score?

Lenders will typically make a hard inquiry into your credit report when you apply for any type of credit account, including a personal loan for debt consolidation. And it may cause your credit score to drop a few points.This hard inquiry won’t remain on your credit report forever, though — it usually drops off within one to two years. By consolidating high-interest debt into a personal loan with a lower interest rate and paying down that debt, your credit score will likely improve.Two of the biggest factors in calculating a FICO® Score (most commonly used by lenders) are payment history, which accounts for 35% of your score, and amounts owed, which accounts for 30% of your score. 
  • Payment History. Making regular, on-time payments can positively affect your credit score and will indicate to lenders that you are a responsible, low-risk borrower. If you miss payments or consistently make late payments, your credit score could be negatively affected and lenders may see you as an irresponsible, high-risk borrower.
  • Amounts Owed. By paying down your debt balance using a personal loan for debt consolidation — which is an installment loan, not revolving debt — you’ll be decreasing the percentage that you owe on outstanding debts. Keeping your credit utilization below 30% of your available credit is recommended.

Debt Consolidation Loan Alternatives 

Maybe you don’t think taking out a personal loan to consolidate your debt is the best solution for you or perhaps you don’t qualify for a loan, and you’re wondering what options you might have. There are a few other tools that you can use.

Debt Settlement

Settling your debt for less than what is owed is the goal of debt settlement companies. For a fee, which can sometimes be hefty, a debt settlement company will negotiate with your creditors —  and debt collection companies if your debt has been sent to collections — for you. This can be a strategy used to avoid bankruptcy, but it’s wise to thoroughly vet any companies you’re considering because scams do exist in this area. Using a debt settlement company may hurt your credit. Typically, you pay the debt settlement company instead of your creditors directly, which means you might fall even further behind on your debts than you were before. Debt settlement companies generally ask that you pay them, not your creditor, while they negotiate on your behalf. Then the company will pay the creditor out of those funds when the negotiation is complete. Even after a debt is settled, how it’s reported to the credit bureaus is up to the lender. They will often close the account and report it either as “paid-settled” or “paid as agreed,” with the latter having less of a negative impact on your credit score.

Home Equity 

It’s not uncommon for a person’s home to be their largest investment and, therefore, their largest asset, although not a liquid asset.Your home equity is based on the current value of your home minus how much you owe on your mortgage. For example, if your home is valued at $200,000, and you owe $125,000 on the mortgage, you would have an estimated $75,000 worth of equity. Lenders will typically lend up to 80% of the amount of home equity to qualified applicants. In the above example, you might be able to borrow up to $60,000 in the form of a home equity loan or home equity line of credit (HELOC), as long as you meet the lender's qualification requirements. Since home equity loans and HELOCs tap into the equity in your home, you must pledge your home as collateral to guarantee the loan. If you do not pay the loan, you risk losing your home.

Getting Help Through Credit Counseling

Working with a nonprofit or for-profit credit counseling service is an option some people choose, also. Credit counseling companies can work with you in putting together a Debt Management Plan (DMP) to pay your debts, but will also teach you about handling your finances. A credit counselor might help you set up a budget, discuss the reason for the debt, make a plan to stay within a budget in the future, and how to use credit wisely.Working with a legitimate, nonprofit credit counseling company is recommended by the Federal Trade Commission. There will typically still be a fee, but may be lower than that of a for profit credit counselor. A nonprofit company will also be less likely to suggest programs for which they receive income, such as a bonus or referral fee.  

Debt Management Vs Debt Consolidation

A credit counseling agency will create a DMP and negotiate with your creditors. You pay the agency, and they pay the companies you owe money to. It’s a long-term relationship, usually three to five years. As a stipulation of the DMP, you may be required to close all of your credit accounts and not open any new accounts. If this is a restriction you cannot abide by, this might not be the right plan for you.You manage debt consolidation using a personal loan. This means, however, that you must use the loan proceeds to pay the debts being consolidated and not be tempted to use the funds for something else. And you aren’t restricted from opening any new credit accounts, so you have to be careful about not adding even more debt to what you already have. 

Debt Settlement Vs Debt Consolidation

With debt settlement, you negotiate an agreement with the lender that permits you to may help you pay your debt at an amount you can afford, but it is not without consequences. The lender may report the debt settlement to the credit bureaus as “settled” instead of “paid in full,” which can negatively impact your credit score for up to seven years. Also, canceled debt may be taxable — talk to a tax professional to see how you should report any canceled debt on your tax return.Using a personal loan for debt consolidation when you intend to pay the whole amount you owe can, in time, have a positive impact on your credit score by showing regular, on-time payments and decreasing the total amount you owe.

Getting a Debt Consolidation Loan 

Every lender will have a specific list of qualifications, but typical requirements are:
  • You must be at least 18 years old.
  • You must be a U.S. resident.
  • Not currently in bankruptcy or foreclosure. 
  • To qualify for favorable interest rates and terms, have a credit score that’s above the mid-600s. 
  • Have a debt-to-income ratio below 45 percent.

Finding a Loan That Works for You

Comparing lenders, their interest rates, fees, and other charges is a good strategy to find the loan that is best suited for you.Some lenders have expertise in debt consolidation and will send your loan proceeds directly to your creditors and report payments to the three major credit bureaus. Some also offer free financial education, which can be helpful as you try to make smart financial decisions to reach your financial goals.

Organizing Your Information and Applying for Personal Loans for Debt Consolidation  

Before applying for a personal loan for debt consolidation, a little prep work may help you qualify for a favorable interest rate and terms that fit your budget with a lender you feel comfortable doing business with. 
  • Request free copies of your credit report from Equifax, Experian and TransUnion at AnnualCreditReport.com
  • Review your credit reports thoroughly, reporting any inaccuracies or errors to the pertinent agency. 
  • You might consider checking your credit score using a reputable company that does not charge you for the service. 
  • If your credit score is too low to qualify for favorable rates and terms, you might want to consider waiting until you can make some positive changes to your credit report before applying for a loan.
If you’ve checked your credit report and are confident in proceeding with the personal loan application, gathering relevant paperwork is the next step. You’ll likely need to verify your legal name, current address, and income. Your lender will let you know exactly what documents they will accept and what information they need to verify.

Typical Debt Consolidation Loan Interest Rates 

Your credit score is a big factor in determining what personal loan interest rate you’ll qualify for. Higher credit scores typically qualify for more favorable interest rates and terms.On average, a loan applicant whose credit score is at the low end of the range may only qualify for rates of 22% to 30%, if they qualify at all.A loan applicant who has a higher credit score, perhaps over 700, may qualify for a rate as low as 9% to 13%.  

The Takeaway

When you’re looking for a personal loan for debt consolidation, comparing interest rates, fees, and other charges a lender might add will help you find the best lender for your financial situation. Lantern by SoFi can help you compare lenders with just one application. And a personal loan to consolidate your debt may be one way to get on a healthy financial path, simplify your money management, and potentially pay off your debt sooner.Learn more about personal loans for debt consolidation at Lantern by SoFi.
Photo credit: iStock/vorDa
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)This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice. SOLC112214

About the Author

Sheryl Nance-Nash

Sheryl Nance-Nash

Sheryl Nance-Nash is a freelance writer specializing in personal finance, business, and travel. Her work has appeared in Money Magazine, Newsday, The New York Times, Business Insider, BBC.com, AARP the Magazine, ABCNews.com, Forbes.com, among others.
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