A personal loan is money that you borrow from your bank, credit union, or an online lender. The loan is paid back in fixed monthly payments, generally over a term ranging from two to five years. Unlike an auto loan or a mortgage, personal loans are unsecured — meaning they don’t require you to provide collateral.

Personal loans can be used for any purpose. But one of the best reasons to take out a personal loan is to consolidate high-interest debt. Depending on your creditworthiness, you may be able to get a substantially lower interest rate than you’re currently paying. That’s one of the best personal finance moves you can make, because it can save you hundreds or thousands of dollars in interest payments.

In this article, we’ll explore whether this is the right approach for you, and highlight some of the personal loan options (and similar alternatives) that are available.

The Pros and Cons of Personal Loans Debt Consolidation

Pros

  • You’ll save money. Consolidating high-interest debt (like credit card debt) into a single low interest (or lower interest) loan will almost always result in substantial savings.
  • You’ll boost your credit score. One factor in your credit score is your credit utilization, which is the percentage of your available credit you’re actually using. Consolidating your debt into a personal loan reduces that utilization and, in most cases, your credit score will increase as a result.
  • It makes it easier to pay off your debt. If you have debts spread across multiple lenders, it can be difficult to prioritize them as part of a debt payoff strategy. Consolidating multiple debts into a single loan simplifies your approach and makes it easy to focus your efforts on eliminating that one lump sum.
  • Your financial life will be simpler. You’ll only have one payment to keep track of every month, which makes it easier to avoid late fees and other expensive administrative mistakes.

Cons

  • Some personal loans offer variable rates. A variable rate depends on both market conditions and your credit score. That means that if rates go up, you could find yourself paying more in interest than you started with. The opposite is a fixed rate, which is locked in for the lifetime of the loan.
  • Some loans come with fees, including a loan application fee, origination fee, and prepayment penalties (which are fees charged for paying off the loan early). Be sure to read the fine print and factor any fees into the overall cost of the loan.
  • Not all personal loans have a fixed term. This can cause you to pay more over the life of the loan. That’s particularly true if the new monthly loan payments are lower on a per-dollar-borrowed basis than you’re currently paying, because lower monthly payments means you’ll carry the debt for a longer period of time (thus paying more in interest).
  • A personal loan is not a useful personal finance tool if you don’t address the reason you found yourself needing one. (See below…)

Debt Consolidation Is a Treatment, Not a Cure

People find themselves exploring personal loans for debt consolidation for a variety of reasons. Some of those reasons are beyond their control, but more often than not the opposite is true and debt problems are self-inflicted wounds caused by financial habits that need to be changed.

Before taking out a debt consolidation loan, analyze why you need one. Are you making too little money, no matter how tightly you budget?  Are you making good money but buying things you simply can’t afford? There’s no shame in the answers to these questions. But you can only improve what you’re willing to be honest with yourself about.

Whatever the causes of your current situation, it’s important to acknowledge and address them. If you don’t, a debt consolidation loan can actually make things worse — especially if used to pay off credit card debt. That’s because suddenly, all those maxed-out credit cards will have plenty of room for more spending. And while you might be thinking, “I would never make that mistake again,” it’s not always that easy in practice.

After all, debt isn’t a character flaw. You didn’t rack up credit card balances because you’re an irresponsible person. The fact is that life is hard and full of wants, needs, and social pressure to spend money.

If you want to avoid falling into the debt trap again, you need to develop a specific plan of action.

So before taking out a loan, you should do the following:

  • Create a realistic budget. If there isn’t enough money to meet your basic expenses, you have to find ways to earn more or drastically cut your expenses.
  • Analyze your spending. Some people have a bare-bones budget, but most of us can afford to make a lot of cuts in our discretionary spending. So as you create your budget, think about whether you could really buckle down for the next six to 12 months and get your debt under control without locking yourself into a new loan. If you can, you’ll save a ton of money by dealing with the debt immediately.  
  • Create an emergency fund. Without an emergency fund, you may be going into debt to cover unexpected but necessary expenses like medical bills or home and car repairs.

When Using a Personal Loan Makes Sense

A personal loan is typically used to pay off unsecured debt (like credit card debt). This is one of the best uses, because credit card debt continues to grow until it’s completely paid off. This can take years and you often end up paying more in interest than you paid on the balance.

In some cases, a secured debt (like a car loan) can benefit from debt consolidation. One example would be if you had poor credit when you financed the car and have a high interest rate on the loan. If your score has improved since then, a personal loan may have a lower interest rate than the car loan.

Be careful, though: if you take out a personal loan with a low rate but a long repayment term, you may actually end up paying more.

If your debt is not totally out of control but could reach that point, a personal loan can help you to get on top of your debt before that happens. For example, perhaps you were unemployed and putting necessary expenses on credit cards, but have since found a job. In a case like that, a personal loan empowers you to pay that debt off quicker than by using your salary alone (which saves money on interest).

Whatever the reason, people with a credit score good enough to get a personal loan at a lower rate than the debt they wish to pay off are the best candidates for this method of debt repayment.

In other words…

Excellent credit makes it an excellent option.

Good credit makes it a good option.

Bad credit means you won’t have much luck with this approach.

If you’re not sure which bucket you fall into, Credit Sesame will give you a free copy of your credit score and provide actionable tips for improving it.

Options for Personal Loans for Debt Consolidation

There are more options than ever when it comes to finding a personal loan. That’s a good thing, as more competition means better deals for consumers.

Online Lenders

Online lenders have transformed the personal loan space. What used to take days or weeks (and reams of paperwork) can now be handled within a day or two (and usually entirely online). Even better, lenders like Credible allow borrowers to “window shop” for a loan that best fits their needs.

We like Credible because the application process is simple, fast, transparent and easy. Potential borrowers can answer a few simple questions and see several loan offers from different lenders, all with no impact on their credit score.

You can then browse interest rates, loan terms and fees, and choose the right loan for you. Once approved, you can have the money in your bank account in just a few business days.

Traditional Banks

Brick-and-mortar banks offer personal loans, but typically require a lot more paperwork and take longer than similar loans from other sources. It’s best to apply with a bank that you already have a relationship with (i.e., the bank where you have your checking and personal accounts).

Credit Unions

Credit union members have a stake in the institution and will often find better rates and service than at a traditional bank. Additionally, credit unions may consider factors other than a customer’s credit score when deciding whether or not to issue a loan. So, if you don’t have ideal credit but do have a high salary, or if you have a low debt-to-income ratio (DTI), a credit union may be a better option than a bank.

0% Balance Transfer Credit Card

Depending on how much credit card debt you have (and your credit score), a balance transfer card can be a great way to save on interest. With this approach, the balance of your card (or cards) is transferred onto the new card.

In most cases — at least any cases worth considering — credit cards offer an introductory period (usually between six and 24 months) during which the transferred balance does not accrue interest. During that period, all of your payments are applied to the principal — which makes it much easier to actually pay down the balance.

With that said, you need to really buckle down and get the debt paid before the 0% APR period ends. If you don’t, the remaining balance will be subject to the new APR (which could be higher than that of the original card).

If you decide to go this route, create a budget and cut as much discretionary spending as you can. Every penny of that savings should go to paying off the balance during the promotional period.

One option we like is the U.S. Bank Cash+ Visa Signature Card, which offers a 12-month 0% APR period on balance transfers with no annual fee and a $150 sign-up bonus. That card usually requires good/excellent credit, so if you have average credit you might want to look into the ABOC Platinum Rewards Mastercard Credit Card.

Keep in mind that balance transfer promotions change constantly, so check the list of current offers to make sure you’re getting the best possible deal.

Meet Tally

If you have debt and have trouble managing it, Tally (also known as Meet Tally) may be just what you need. Tally is an automated debt management app that extends users a line of credit that’s used to pay off your credit card debt.

You have the option to let Tally make your payments. If you do, the app will pay the highest-interest debts first, following the avalanche method of debt repayment (which saves you the most money).

You can read more about how Tally works in my in-depth review of the service.

Friends and Family

It’s always a gamble to borrow money from friends and family. Loans can damage relationships, so if you choose this method of debt repayment, it’s a judgment call. But if your credit isn’t good enough for the other options we’ve listed, and you have someone in your life willing and able to help you, it can certainly improve your financial situation.

If you go this route, make sure you draw up a contract that lays out the details of the loan agreement (even a simple one) and treat the loan just like a loan from a bank: pay on time, every month, without being asked or reminded.

That probably seems like simple/obvious advice, but you’d be shocked by how many people borrow money from family members and then treat their relationship as an excuse for lethargic repayment.

Home Equity Loan

A home equity loan is basically a second mortgage. You can borrow against the equity in your home and use the money to pay off debt. The recent average interest rate on these loans has hovered a little below 6%, which is likely far lower than whatever debt you’re trying to pay off. So if your credit score is good enough, a home equity loan is a good option.

Do keep in mind this is a secured loan and the collateral is your home.

Peer-to-Peer Lending

Peer-to-peer lending is essentially crowd-sourcing a loan. Everyday people are the lenders, not a bank or credit union. The lenders make the loans for the same reasons banks do — to make money via the interest the borrower pays.

Frequently Asked Questions about Personal Loans

Is it smart to get a personal loan to consolidate debt?

If your credit history allows you to get a lower interest rate than you’re currently paying, and you can ensure that you won’t go into debt again, a personal loan is a powerful personal finance tool. But if your FICO score is low, work on increasing it and then revisit taking out a personal loan. And if you have a cash flow or spending problem, spend several months improving that situation first. Otherwise, you put yourself at risk of just taking on more debt with your newly-empty credit cards.

What credit score do I need for a debt consolidation loan?

You don’t need perfect credit to get a debt consolidation loan. Most lenders are looking for a score of at least 630 or 640. You can certainly find lenders who will approve much lower scores, but that’s not a good thing: typically, those lenders will charge a high interest rate and expensive fees.

Can I get a debt consolidation loan with a high debt to income ratio?

Most lenders want borrowers with a debt-to-income ratio below 50%. There are some specialty lenders who will make loans to borrowers above that threshold, but the loans may come with high interest rates and expensive fees.

Do consolidation loans hurt your credit score?

Shopping for loans with an online lender like Credible will not impact your credit score. Once you apply for a loan the lender runs a hard check on your credit report, which does drop your score by a relatively small amount for a short period of time. But if you’re using the loan to pay off credit card debt, the reduction in credit utilization will improve your credit score.

What is a good APR for a debt consolidation loan?

Like any loan, the lower the interest rate the better. In the case of a debt consolidation loan, if its interest rate is lower than that of the debt you’re paying off, it’s a good APR. But keep in mind that the term of your new loan will affect how much interest you’ll pay, which means the lowest rate might not always lead to the most savings. Make sure you fully understand the details of a loan’s repayment terms, and compare the repayment terms of multiple options.

Can you use a personal loan to consolidate student loans?

Yes. In fact, there are lenders who specialize in refinancing student loans. Do keep in mind that if you refinance federal student loans you lose access to the various repayment programs those loans offer, including income-based/income-contingent repayment plans and their corresponding forgiveness programs (which wipe away your remaining loan amount after 10 years of qualifying payments).

Personal Loans and Debt Consolidation – My Final Thoughts

Debt consolidation loans certainly carry a lot of benefits. You’ll stand to save a lot of interest payments, while simplifying the number of payments you make. They can help you break out of the paycheck to paycheck cycle, and they can help you prevent your debt from getting out of control. But, as discussed, there are drawbacks as well.

Whether you’ll benefit with a debt consolidation loan comes down to your actions after the fact. If you’re seriously ready to make a change, and there is a strategy to do so in place, debt consolidation loans are immensely helpful.

Don’t have a strategy in place? Not ready to change? Then I’d hold off on a loan before moving forward.