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How a Personal Loan Works for Debt Consolidation

A debt consolidation loan may help with a faster pay off — and possibly improve your credit score.

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Why a Personal Loan Could Be Smart for Paying Off Your Debt

A personal loan for debt consolidation is a way to simplify your finances, save money on interest payments, and focus your efforts towards one monthly payment.

A Debt Consolidation Loan: How It Works

When you have high-interest debt, typically from credit cards, you end up paying a lot of money toward interest. A debt consolidation loan gives you immediate cash to pay off your high-interest debt and replaces that debt with your new loan. If your new loan has a lower interest rate than you were paying on your old debt, you could save money on interest, while also having lower monthly payments.

People who choose to consolidate debt often have many sources of high-interest debt. For a real-world example, let’s say you had $6,000 in credit card debt at 16% interest, $2,000 remaining on an auto loan at 9.5% interest, and $4,000 in medical bills, with a late fee of $100 added each month until it is paid off.

Benefits of Consolidating Debt Infographic

If you took out a $12,000 debt consolidation loan at 8.5%, you could use those funds to pay off all your other debt immediately. And you would save 7.5 percentage points of interest on your credit card debt, 1.0 percentage point on your auto loan, and you’d avoid the $100 monthly late fee your medical provider was charging. Over the long run, you could save money — and, if the term lengths of your new and old debt were the same, you could have a lower monthly payment.

What Are Debt Consolidation Loan Rates and Terms?

The rate you receive depends on your credit score, your loan size, your loan term, your monthly income, and other factors. Rates also depend on the broader rate environment. Rates on an unsecured Personal Loan through Old National Bank are up to 25.00% APR.

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The loan term, also known as the length of the loan, is also an important decision. Typically speaking, the shorter the term, the lower the interest rate. In fact, you save quite a bit of interest by paying off your loan faster — not only is your rate typically lower, but the principal has less time to accrue interest. 

So why doesn’t everyone always opt for the shortest term? It’s the monthly payment — the only way to pay off the loan faster is to make bigger monthly payments. Not everyone has the cash flow to afford that. When deciding on a term that is right for you, you should strike a balance between saving on interest and making sure that the monthly cost is manageable.

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If you make your payments regularly, a debt consolidation loan will not hurt your credit score. In fact, over the long term, there are two ways it may help your credit score.

First, if you already have some late payments on your record, due to overwhelming debt, a personal loan may allow you pay those debts off and transition to affordable monthly payments. By regularly making all your payments on time, you will eventually build back your credit score.

Second, a large portion of your credit score is based on your revolving credit — in other words, your credit cards. How high is your balance? And how does this compare to the balance you are allowed? This is known as your credit utilization ratio.

As an example, say you have one credit card, and you are in debt: you have a $6,000 balance on a credit card that allows you an $8,000 line of revolving credit. Even if you always make your minimum monthly payments, your credit utilization ratio would be 75%. This is an extremely high amount. Credit monitoring services typically want to see this ratio below 30% — and the lower the better.

By using a debt consolidation loan to pay off the balance without closing your account, you can transition to far lower balances that get paid off in full each month. This will improve your credit utilization ratio, which, in turn, may improve your credit score relatively quickly.

Lastly, you should be aware that any loan application that involves a hard credit check will temporarily have a small negative impact on your credit score. However, talking to a lender about the possibility of a loan, or getting a soft rate quote will not affect your credit score.

What is an Unsecured Debt Consolidation Loan?

People often wonder what “unsecured” means. An unsecured loan means that a loan requires no collateral. What is collateral? Think of it as a guaranteed asset. The classic example is a mortgage loan, where the house is used as collateral. If the borrower defaults on their mortgage payments, the bank has the right to take possession of the house to recover the cost of the loan.

With an unsecured debt consolidation loan, the borrower is not required to put up any collateral. This means that borrowers can get a loan without pledging a home, a car, a jewelry collection, or other valued possession as collateral.

While the best loan rates are generally reserved for those that put up substantial collateral, an unsecured loan has several benefits:

  • You avoid appraisal fees — and the headache of scheduling an appraisal
  • Banks typically make much faster decisions on unsecured loans
  • The loan is available to those without collateral

As a borrower, you may also feel a sense of relief, since you know that your home — or other valuable asset — isn’t on the line with an unsecured loan.

Debt Consolidation with a Personal Loan: Pros and Cons

There are many pros to consolidating your debt.

  • A debt consolidation loan may allow you to pay a lower interest rate on your outstanding debt, including a lower monthly payment.
  • One monthly payment means you are likely to simplify your bills and billing cycles, making the payment process much more straightforward.
  • You may end up building your credit score through regular on-time payments.
  • By paying off large credit card balances, you may improve your credit utilization ratio — a key component of your credit score.

One con of this type of loan is that if you have particularly poor credit, you may not qualify or you may not get a rate that helps you save on interest.

The other con is in how a debt consolidation loan is treated. Some people consider it the solution to all their financial problems. However, this type of loan does not address the underlying issue: that the borrower found themself swamped by debt in the first place. Unless the borrower also takes steps to decrease their dependency on credit, reduce their overall expenses, and boost their savings, they may very well find themself in the same situation several years later.

If you are considering a debt consolidation loan, it makes sense to apply, or at least see your rate. If you are serious about getting out of a cycle of debt, you may also consider pairing a debt consolidation loan with credit counseling, money management education, or financial planning. That way, you have your options in front of you as you start to tackle your high-interest debt.

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Getting connected with a Banker will not affect your FICO® Score

**The rate quote that will be provided in response to a request represents an estimate based on preliminary information provided by the client. It will not be representative of available product rates and terms based on the specific credit qualifications of the requestor. If specific product eligibility, rates and product terms are desired, an application will need to be submitted and authorized consent to pull a credit bureau report will need to be provided by the applicant. The only way to obtain exact rate and payment information is to apply.

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1 Calculations are for estimated analysis only. Results are not indicative of any actual loan terms or payment amounts. Please contact Banker for current rates and to get your free personalized rate quote.