Debt consolidation vs. personal loan—know the difference
Wondering whether you should take out a debt consolidation or personal loan?
Are they the same thing? Are you confused by the way different providers describe what appear to be similar products?
You are not alone. These terms are often thrown around interchangeably—which might create the impression they’re the same. But are they?
The short answer is yes… and no.
Keep reading to learn the nuanced differences between these two credit products. In just a few minutes, you’ll understand the use of each type of loan—as well as their unique benefits and drawbacks.
By the end, you'll feel more confident finding your ideal loan match.
What’s a personal loan?
A personal loan is one where the borrower obtains an upfront lump sum of money that must be paid back over a predetermined period.
Consistent and recurring payments, known as installments, are made until the balance is cleared. Personal loan terms typically range from 12 months to seven years, though exceptions exist.
Personal loans come in two primary forms:
- Unsecured: Most are unsecured. This means no upfront collateral is required to obtain the loan. Instead, it’s provided based on the borrower's creditworthiness.
- Secured: Secured personal loans require collateral, like your home or savings account. The lender can take the collateral if you fail to repay the debt.
Personal loans can be used for a variety of purposes, like:
- Home renovations,
- Moving expenses,
- Medical bills,
- Or even debt consolidation.
Personal loan: pros and cons
|Personal loans are typically approved faster than other loans, like mortgages.
|Often requires better credit scores to obtain approval.
|Most personal loans do not require collateral.
|Unsecured personal loans may have higher interest rates than comparable secured loans.
|Personal loans are versatile and can be used for various purposes.
What’s a debt consolidation loan?
A debt consolidation loan is actually a specific type of personal or business loan.
It involves the borrower merging multiple existing debts into a single balance, often with a lower interest rate. By combining obligations into one monthly payment, these loans help simplify debt management.
Debt consolidation loan: pros and cons
|Simplifies debt management by combining multiple commitments into a single monthly payment.
|Some lenders charge origination fees.
|Consolidating debt often leads to a lower interest rate.
|It may require collateral, like your car or house.
|While it can harm it initially, eventually, consolidation can help your credit score.
|By committing to a fixed repayment schedule, the borrower gets the peace of mind of knowing exactly when the debt will be paid off.
Personal loan vs. debt consolidation loan
While it’s true that debt consolidation loans are a type of personal loan, in practice, the terms are often used to describe different products.
Most of the time, when someone refers to a personal loan, they’re referring to a loan intended for a singular purpose, like purchasing a new boat or building a pool.
On the other hand, debt consolidation loans refer to those used to merge multiple existing debts. Again, these can be either personal or business loans.
Debt consolidation is the intended use of a personal loan. In other words, it’s a personal loan used to consolidate debts instead of renovating a home, buying a car, or paying for a wedding, for example.
|Debt consolidation loan
|Personal loans can be used for various purposes, like paying for a vacation.
|Used solely to combine multiple existing debts into a single balance.
|Depends on the borrower's creditworthiness and the lender’s policies.
|Usually, a lower rate than the average of the existing debts.
|Similarly, based on the borrower's creditworthiness and the lender’s policies.
|Based on the borrower’s existing debts and the lender’s policies.
|Repayment period (term)
|Varies widely from 1 to 7 years, depending on the type of personal loan.
|Usually, 3 to 5 years.
Credit score impact
Debt consolidation loans are simply a type of personal loan. It often requires a hard inquiry, which can initially negatively impact your credit score. But they have no different impact on your creditworthiness than a personal loan per se.
Over time, however, if the loan is diligently paid back, it can improve your credit score.
Debt consolidation loan alternatives
- Debt management plans (DMPs): A credit counseling agency can help you develop a plan with your creditor to repay your debt. This is not the same as debt consolidation. With DMPs, your existing loans remain, but the payment details will change to more manageable terms.
- Debt settlement: A debt settlement involves negotiation with your creditor to lower your balance. In many cases, borrowers will hire a third party to complete the negotiations. Debt settlement comes with a cost, however. Renegotiating existing debts with your creditor can harm your credit score. Moreover, there’s no guarantee the creditor will agree to the new terms.
- Balance transfer credit card: This strategy involves moving your debts to a credit card with a lower interest rate. In many cases, issuers will offer 0% promotional interest rates for a limited time. While 0% interest is excellent, the rate can jump substantially once the promotional period ends. Ensure you fully understand the terms and have the ability to make timely payments before pursuing this option.
- Home equity loan or line of credit: Borrowers who own their house can borrow against their home equity to cover their debts. While rates are often lower, it puts your home at risk if you default on payments.
- 401(k) loan: A 401(k) loan involves borrowing from your retirement savings. Like home equity loans, however, it puts your retirement savings at risk if you cannot pay off your obligations in a timely manner.
- DIY: Some individuals thrive with a do-it-yourself approach. Following a well-known debt management strategy, like the debt snowball method, can be helpful. This can be a great option if you possess the motivation and discipline it demands.
- Bankruptcy: Sometimes, the best option, and only one, is bankruptcy. This is almost always a last-resort solution and shouldn’t be taken lightly. Likely, declaring bankruptcy will severely impact your credit score for years.