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If you’re having trouble managing your debt, you may be considering debt consolidation or debt settlement. Debt consolidation and debt settlement are both forms of debt relief that may help you manage your debt, but they have very different functions. In general, debt consolidation reduces the number of creditors you owe, while debt settlement reduces the total debt you owe.
Each option has its challenges and drawbacks—not everyone is in the right situation to consolidate or settle debt. Depending on your overall finances, credit score, amount of debt and other factors, debt consolidation or debt settlement may or may not help.
Here we explore debt consolidation, debt settlement and how to decide which approach, if either, is most beneficial for your financial situation.
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Debt Consolidation
Debt consolidation is a form of debt relief that combines multiple debts into one new consolidated debt. Instead of owing money to multiple creditors and having multiple monthly payments, debt consolidation lets you reorganize those debts into a single combined total. A couple of the most common ways to consolidate debt include 0% balance transfer credit cards and debt consolidation loans, or personal loans, from a bank or credit union.
Typically, with debt consolidation, your old debt gets paid off by the new loan. For example, if you currently owe a total of $15,000 on three different credit cards, you could get a personal loan for $15,000 and then pay off the balances of those three credit cards with the funds from your new loan. You’ll still owe $15,000, but the debt will be all in one place with one monthly payment, and possibly at a lower interest rate. When a debt consolidation loan comes with a lower interest rate, you can pay off the debt sooner and with a lower total cost.
It’s important to remember that you’ll still owe the same amount of principal balance if you choose debt consolidation. And, if you decide to keep borrowing money on top of your consolidated debt, you may encounter financial difficulty.
Debt consolidation may offer more visibility and control over your debt. Combining all of your debts into one could provide you with more determination to pay off the debt once and for all.
When Debt Consolidation Makes Sense
Debt consolidation may be the right choice in a few different circ*mstances:
- You want to simplify your debts. Instead of multiple debts and multiple monthly payments, you can combine your debts into one. If you are having trouble making numerous monthly payments, debt consolidation could help reduce your financial stress.
- You can get a lower interest rate. Debt consolidation may be a good choice if you can get a lower interest rate on the consolidated debt. For example, if you can combine multiple high-interest credit card balances onto a limited-time 0% APR balance transfer credit card, this may help you pay off your debt faster.
- You are ready to make a plan to pay off debt. Even if you’re not experiencing financial stress, debt consolidation may help you get your debt under control or pay off your debt altogether. If you want to focus on paying off debt, debt consolidation may help you reduce your interest rate, get better organized about paying off debts and otherwise put you in a stronger financial position.
Alternatives to Debt Consolidation
Debt consolidation is something you manage yourself. But you may need a different level of help. One alternative is a debt management plan from a consumer credit counseling service
If you are going through financial difficulty, consumer credit counseling services can help you repay your debts by developing a payoff plan for you. If you sign up for this type of program, the consumer credit counseling service will work with your creditors and attempt to reduce your interest rate and fees.
With a debt management plan, you generally make one monthly payment to the consumer credit counseling agency, which then forwards payment to your creditors. They do not renegotiate the total amount of debt, but they help you make a plan to pay off your debt, while potentially helping reduce fees and costs.
Debt Settlement
Debt settlement is another form of debt relief that is sometimes compared to debt consolidation, but it’s quite different. Unlike debt consolidation, where you ultimately pay off the entire balance of your debts, debt settlement is a form of debt forgiveness in which your creditors agree to let you pay a lesser amount of what you owe.
Debt settlement can be risky and is generally considered an option of last resort. If you’ve exhausted all other options, then debt settlement may seem like the right path. Even then, many experts advise exploring other options.
Indeed, it’s important to be aware of the risks. Debt settlement typically involves going delinquent on your bills and then settling with the creditors for a smaller percentage of what is owed. This can damage your credit score and appear on your credit reports for up to seven years. There is no guarantee that your creditors will agree to settle your debts—they may choose, instead, to sue you for repayment. If you succeed in having any debts forgiven, the forgiven amounts can become taxable income that gets reported to the IRS, requiring you to pay taxes on the amount that’s forgiven.
Debt settlement is an option that you can manage on your own if you are comfortable talking with your creditors and asking to make a deal on your debts.
There are also debt settlement companies that will offer to negotiate with your creditors for you in exchange for a fee, which is often 15% to 25% of the total enrolled debt. As part of the debt settlement process, these companies will ask you to make payments into a separate account that they set up for you. This cash is then used to pay off your settled debt amount after negotiations with creditors.
When Debt Settlement Makes Sense
Debt settlement can be risky and complex. There’s often a better alternative, but if you feel you’ve exhausted all other options, here’s when debt settlement may be an option:
- You’re out of options. If you have less than perfect credit, don’t want to apply for any more loans and can’t qualify for a lower-interest debt consolidation loan or balance transfer credit card, you might consider debt settlement.
- You don’t want to declare bankruptcy. If you’re not able to declare bankruptcy or have debts that can’t be discharged in bankruptcy, debt settlement might be an option.
- You’re willing to take a hit on your credit report. If your debts have become so unmanageable and stressful that you are willing to risk taking a hit on your credit report due to delinquency, you could pursue debt settlement.
Alternatives to Debt Settlement
Instead of hiring a debt settlement company, you’ll often get a better deal for your overall financial situation by working with a consumer credit counseling agency. Instead of going delinquent on your debts and potentially taking a hit on your credit score, consumer credit counseling can help you stay current on your bills and pay off debt without the potential risks and longer-term consequences of debt settlement.
Debt Consolidation vs. Debt Settlement
| Debt Consolidation | Debt Settlement | |
|---|---|---|
| How It Works | It aims to reduce the number of creditors you pay by combining your debts into one new loan. | It aims to lower the total amount of debt you owe. As a form of debt forgiveness, you or a company negotiate with creditors to reduce your debt obligation. |
| Does It Affect Your Credit Score? | It may cause a slight dip in your credit score initially, but it can help improve your credit score in the long term by reducing your credit utilization ratio. | It can cause a significant hit to your credit score, since it typically requires you to go into delinquency on your debts. |
| What Does It Cost? | You might have to pay a loan origination fee to take on your new debt consolidation loan. Interest rates for loans vary. | Debt settlement companies generally charge a fee of 15% to 25% of the total amount of enrolled debt. Debt settlement may not cost anything if you manage the process yourself, without hiring a company. |
| Advantages | Debt consolidation loans or 0% balance transfer credit cards may help you get a lower interest rate on your debts and help you pay off debt faster by reducing your interest charges. Combining multiple debts into one can help simplify and focus your finances. | Debt settlement may help reduce the total amount of debt you have to repay. |
| Disadvantages | Debt consolidation does not eliminate your original debt; it reorganizes it. If you keep borrowing and don’t pay off new debts on time, you may end up deeper in debt. | The debt settlement process is risky. There’s no guarantee that your creditors will forgive or negotiate your debt. It can be detrimental to your credit score. And it can be costly. |
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Frequently Asked Questions (FAQs)
How does debt consolidation work?
Debt consolidation works by combining your existing debts into one new debt, ideally at a lower interest rate. For example, let’s say you owe $2,500 on one credit card, $5,000 on another card and $7,500 in other debts. You could get a debt consolidation loan for $15,000. Once you pay your preexisting debts with your new debt consolidation loan, you make a single payment on your new loan each month.
What is a consumer credit counseling service?
Consumer credit counseling organizations are generally nonprofit organizations offering certified and trained counselors. These counselors can help you manage your money and debt, create a budget and educate you on financial issues.
Some credit counseling organizations will help you create and implement a debt management plan for your debts. With this type of plan, you still pay the total amount of principal you owed. You make a single payment to the organization each month and the organization makes a payment to your creditors.
Can I negotiate a debt settlement on my own?
The first step of the DIY debt settlement negotiation process is to dig into your debts to assess how much you owe and whether it’s possible to pay without a settlement agreement. Once you’ve done your homework and stashed away some cash, you can start to determine your settlement offer. Creditors may agree to accept 40% to 50% of what you owe.
It’s important to remember that most creditors won’t negotiate or settle a debt unless you’re significantly behind on payments. And keep in mind that the debt settlement process can take two to four years, depending on the overall amount of your debt and the complexity of your situation.
How does debt settlement affect my credit score?
Debt settlement can be harmful to your credit score because the process requires you to stop paying your bills and go delinquent on your debts. Along with the hit to your credit, some creditors may refuse to negotiate with you and could sue you for nonpayment and garnish your wages. For these reasons and others, debt settlement can be risky and is not an ideal option.
