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If you have multiple sources of debt, you may be curious about the idea of using a personal loan for debt consolidation.
This article will explain how the process works and the pros and cons of using a personal loan to consolidate your debt. We’ll also outline the situations where they make the most sense to consider, and provide some alternative debt consolidation options for situations where they don’t.
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How Using a Personal Loan for Debt Consolidation Works
It’s important to understand that taking out a personal loan means taking on more debt. The main idea is that by using a personal loan to pay off other sources of debt, you simplify your monthly accounting by replacing multiple sources of debt with one.
Assuming you meet the lender’s requirements for a personal loan and the loan is approved, the lender will transfer the loan amount to you in a lump sum. It’s then up to you to use those funds to pay off your other creditors.
From there, you’ll be responsible for paying back the personal loan to your lender based on the agreed-upon loan terms.
Personal loan for debt consolidation vs. debt consolidation loan
Loan titles can get confusing, especially when they are used for the same purpose. A personal loan is one of the most flexible loan types. You can use the funds for almost anything.
Because of that, personal loans sometimes get referred to by what the funds eventually get used for, like a vacation loan or emergency loan. In that same spirit, a personal loan for debt consolidation can sometimes be called a debt consolidation loan.
However, a debt consolidation loan can also refer to a different type of loan. For those loans, the lender will issue payment directly to your creditors rather than giving you the money to pay them off yourself.
The end result is the same, but the mechanics are different. Before committing to a loan, make sure to go over the disbursement and repayment processes with your lender so that you understand what’s expected of you and when.
Should You Use a Personal Loan for Debt Consolidation?
Why do so many people turn to personal loans for debt consolidation? Well, there are several upsides. We’ll go over them here, as well as the risks you’ll need to take into consideration.
Consolidating your debts with a personal loan could save you significantly on interest, especially if you have high-interest credit card debt.
If you can pay off creditors with a personal loan, you can reduce the number of bills you need to pay each month, simplifying your budgeting process.
With a fixed-rate personal loan, you’ll know how much you owe each month through the end of the loan term allowing for a predictable repayment schedule.
Consistent, on-time and in-full payments on a personal loan can raise your credit score.
Credit card minimum payment requirements can be lower than what you’d owe for a personal loan (even though interest rates are usually higher).
You aren’t reducing your debt by taking out a personal loan for debt consolidation – you’re taking on more. This can affect your debt-to-income (DTI) ratio.
If you’re unable to make the payments on your personal loan, you risk negative consequences including damaging your credit score and potentially exposing yourself to litigation from credit agencies.
When To Consider a Loan for Debt Consolidation
There are situations where personal loans for debt consolidation make more sense than others. We’ve listed the most common ones below:
If you have high-interest payments
If you have high-interest credit card debt, using a personal loan to pay it off could save you a considerable amount of money.
While you aren’t reducing the balance of your debt, by getting a lower interest rate you are reducing how much it costs to borrow that money. That can make a big difference.
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If you have trouble managing payments
Coordinating multiple sources of debt can be overwhelming, especially if you’re juggling different minimums due on different dates and paying them from multiple sources.
One of the primary benefits of any type of debt consolidation is the streamlining of your finances. Handling one monthly payment, that’s consistent and due on the same day every month, is an easier mental load for many people.
If you have a good credit score
With a better credit score, you’re not only more likely to qualify for a personal loan but to get the best possible terms from your lender.
This can result in either lower loan fees, a lower interest rate or potentially both. Better terms from your lender give you a bigger advantage from consolidating your debt with a personal loan.
How To Find the Right Debt Consolidation Loan
If you think a personal loan might be the best way to consolidate your debt, here’s how to go about finding the best loan you can.
- Check your credit score: Lenders will review your credit score as part of the loan application. Make sure you have a credit score that’s high enough to qualify. If you don’t, you’d be better off focusing your initial efforts on improving your credit score.
- Talk to multiple lenders: Different lenders offer different minimums and maximums for personal loans. Make sure to take the time to look at the different product offerings and find the one that most closely aligns with your needs.
- Analyze different loan terms: Lenders will charge both fees for issuing the loan and interest on the payments. The annual percentage rate (APR) is a metric that combines those amounts to show you the overall cost of borrowing money. Make sure to compare the APRs for different lenders so that you have a clear picture of what it will cost you to take on that debt.
- Ask about promotions: Sometimes, lenders run promotions that make them a better choice than other lenders. If one temporarily offers a reduced loan origination fee, you should incorporate that into your decision-making process, so be sure to ask upfront.
Alternatives to Personal Loans for Debt Consolidation
Remember, personal loans aren’t the only option for consolidating your debt. Here are some popular alternatives you might want to look into.
Balance transfer credit card
If you have credit card debt, finding a balance transfer card may be the best way to save on interest.
Some cards offer 0% introductory APR periods. In other words, if you can pay off the credit card balance during that promotional window, you won’t be paying anything extra in interest or fees to do it.
However, introductory periods don’t last forever. If you decide to take this route, make sure to pay off the balance before the introductory period ends.
Home equity loan or home equity line of credit
If you own a home, you can borrow against any equity you’ve built up in the property. The two methods for doing so are either with a home equity loan or a home equity line of credit (HELOC).
The mechanics will be slightly different depending on which option you choose, but the big picture is similar. You’ll borrow the money against the equity of your home and you’ll likely pay a lower interest rate than you would for taking out a personal loan. Depending on how much equity you have, you’ll also have the potential to borrow more than you would with a personal loan.
Debt management plan
Debt management plans are available through non-profit credit counseling agencies. With this option, a credit counselor will look over your credit history and spending habits to help you come up with a plan to get out of debt. In some cases, they can also negotiate with your creditors.
Personal loans can be used for many types of debt, from medical bills to car repairs to credit cards. However, they typically aren’t used for secured debt, like a mortgage.
The effects on your credit score are nuanced. In the short term, you could see a dip. But if you’re responsible about making payments on time your credit score should eventually increase.
Unsecured loans will be issued based on your credit history and your DTI ratio. If you have good credit, the process is usually straightforward and often quite fast. If you have a low credit score, it can be harder to find a lender willing to issue you a loan, and even if they do, they’ll likely charge you more in interest.
While technically possible it is not recommended that you do so for Federal student loans. Federal student loans come with some flexibility, such as income-based repayment plans that you would lose access to by doing so.
Final Thoughts on Personal Loans for Debt Consolidation
Debt consolidation is one of the most responsible ways you can use a personal loan. From saving on interest to simplifying your monthly payments, the advantages can be significant. Before committing, make sure to talk to your lender and ensure that you’ll be able to pay back the loan.
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The Short Version
- Pros of using a personal loan for debt consolidation include potentially saving on interest, simplifying your payments, not needing collateral and potentially improving your credit
- The risks include taking on more debt, potentially increasing your monthly minimum and the negative consequences that would come if you fail to repay the loan
- Alternatives for debt consolidation include balance transfer cards, home equity lines of credit and debt management plans