Tens of millions of Americans are struggling with debt and looking for a way out. That search can be confusing: There are many debt relief methods out there, and it’s hard to know which is right for you. Debt settlement and debt consolidation are two of the most common.
Let’s take a closer look at both options, how they work, and how you can decide which is the best option for you.
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What’s the difference?
Debt settlement and debt consolidation are two fundamentally different approaches to tackling debt.
- Debt settlement involves negotiating with creditors and asking them to accept less than what you actually owe as full payment for your debt. It aims to reduce the amount you owe. You may do the negotiating yourself, or you may hire a debt settlement company to negotiate on your behalf.
- Debt consolidation involves taking out a new credit line to pay off several old debts. You will still pay the full amount, but your payments will be simplified, and you may be able to lower your interest rate.
Both of these options are used for unsecured debts, like credit card debt, medical debt, personal loans, payday loans and private student loans. Mortgages, car loans, other types of debts secured by collateral and federal student loans are usually not eligible.
Each of these methods has advantages and disadvantages.
READ MORE: Are you drowning in debt? Here’s how to save yourself
The key differences
|Debt settlement||Debt consolidation|
|How it works||You, or a for-profit debt settlement company, will negotiate with creditors and ask them to accept less than what you actually owe as full payment for your debt.||You take out a new credit line to pay off several old debts. You will still pay the full amount, but your payments will be simplified, and you may be able to lower your interest rate.|
|Types of debt||Virtually all unsecured debts, including credit card bills, medical bills and student loans.||All unsecured debts and even some secured debts can be consolidated, even though it’s not usually considered smart to turn secured debt into unsecured debt.|
|DIY option||You call your creditors and make a settlement offer.||You apply for a debt consolidation loan or new credit card and use that new line of credit to pay off your existing debt|
|Primary benefit||You will get out of debt more quickly by reducing the total amount that you owe.||All of your loans are rolled into one, simplifying your finances|
|Other benefits||Avoid bankruptcy|
No charge-offs on your credit report
You’ll get out of debt faster
|Multiple loan options|
One single payment
Fewer late fees
New loan lowers credit utilization
Ends debt collection calls
Fewer interest charges
|Primary disadvantage||You will have to temporarily stop paying certain debts, so you likely will get calls from debt collectors||This will only work if your credit score is high enough to qualify for new credit|
You may end up with more debt than when you started
|You may end up paying a higher interest rate|
If you aren’t disciplined, you could end up raking up more debt and end up in a worse position
There may be upfront costs
Late payments will set you back further
|Impact on credit score||High: Your settled account will be noted on your credit report and your credit score could fall anywhere from 50 to 200 points, depending on multiple factors.||Low: Credit score will initially fall slightly due to the new line of credit, but as you pay off your other debts and keep making your single monthly payment on time, it will steadily increase|
|Tax implications||The forgiven debt may be considered taxable income||None|
|Payment structure||Once you reach a settlement agreement, you can either make one lump-sum payment or agree on a series of payments over a specific loan term||One monthly payment. You can pay the monthly minimum or pay more each month to pay off your debts faster.|
|Signs it may be right for you||You have more than $10,000 in debt and are only making the minimum payments|
You can’t keep up with your current debts
You’ve missed more than three consecutive monthly payments
You are overwhelmed by your financial situation
You’re facing financial hardship
|You have a good credit score|
You prefer fixed payments
You want one monthly payment
You can afford to repay the loan
You’re committed to fixing your financial situation
Debt settlement options
If you’re thinking about debt settlement, you have two primary options: hiring a debt settlement company or handling the negotiations independently. Here are the key differences:
Debt settlement companies
Debt settlement companies are for-profit enterprises that offer professional negotiating services for debtors seeking settlements.
A debt settlement company will help you set up a dedicated account for debt settlement funds. You will stop making debt payments and pay into this account instead. When you have saved enough, the negotiators will contact your creditors and negotiate settlement offers.
Debt settlement companies are not allowed to charge upfront fees. You will pay a percentage of the savings that the company negotiates, usually from 15% to 25%. You will pay this after the debts are settled.
The average debt settlement customer reduces their debt burden by 30%, including fees, if they complete the debt settlement program. Completion rates average 45% to 50%. Participants often quit because they are unable to save enough to offer settlements.
Pro tip: If you’re looking for a debt settlement company, choose carefully. Not all companies are reputable. Check the company’s record and reputation thoroughly!
READ MORE: What are the pros and cons of debt settlement
DIY debt settlement
Do-it-yourself debt settlement involves the same process without the intermediary. You’ll have to do two things.
- Save money. You’ll need enough cash on hand to offer lump sum debt settlement payments.
- Negotiate with your creditors. You’ll need to initiate contact with your creditor or the debt collector, reach an individual with the authority to negotiate, and persuade that individual to accept a settlement.
This isn’t easy, but if you have the discipline to save money and the knowledge and confidence to negotiate on your own behalf, you can settle your debts without the fees that a settlement company would charge.
Many debt settlement companies have a minimum amount of debt they are willing to handle, often from $7,000 to $10,000. If your unsecured debts are below this level, DIY may be your only option.
READ MORE: Step-by-step guide to DIY debt consolidation
Debt consolidation options
Your primary options for debt consolidation are loans or balance-transfer credit cards. Here’s a closer look at each:
A debt consolidation loan is a personal loan. You take out a loan, use the money to pay off your other debts, and then pay off the personal loan.
You can use any personal loan for debt consolidation, but some personal loans are explicitly marketed as debt consolidation loans. That usually means the lender will pay your creditors directly, so you won’t have to handle the money.
Personal loans often offer terms of three to five years, so they are a good choice if you need an extended time to pay off your debts. You will need to have a good credit score and a low debt-to-income ratio to get the best terms on a debt consolidation loan.
There are plenty of loan options out there, including an array of personal loans for bad credit borrowers.
Pro tip: Make sure to inquire about loan origination fees before you begin the application process. They vary from lender to lender.
Personal loans aren’t your only loan option. If your credit score isn’t perfect, you can borrow from yourself, particularly If you have home equity or retirement savings. These options include:
- Home equity loan or home equity line of credit (HELOC)
- Cash-out refinance
- 401(k) loan
READ MORE: How debt consolidation works and 5 top loan options
Balance transfer credit cards
Many popular credit cards offer a zero-interest promotional period on balance transfers. This period is often 12 to 18 months but may be longer in some cases.
You can use these cards to consolidate debt. You transfer your other balances onto the new credit card. If you can pay off the debts before the promotional period ends, you can cut your interest charges to zero.
You can set up your own repayment plan, and you have some flexibility in the event of a financial setback.
This is a good strategy if you have the ability to pay the debts before the zero-interest promotion expires. If you don’t, you will be right back to paying high credit card interest rates.
Pro tip: If you use this strategy, be sure to make all payments on time. Many card issuers will cancel the zero-interest promotion if you make even one late payment. Make sure you’re fully aware of all repayment terms.
Most balance transfer cards with favorable terms require a good credit score. If your credit is already impaired, this might not be a viable option.
READ MORE: Best balance transfer credit cards
Which is right for you?
Both debt consolidation and debt settlement are legitimate and useful debt relief options, but they are usually used in different situations.
If you can pay your debts and your credit score is good, but you want to simplify your payment schedule and lower your interest cost, debt consolidation is your best bet. Just be sure you have the discipline to stop taking on new debt until your consolidated debts are paid off!
If you have already fallen behind on your payments and you really do not have the ability to pay your debts, debt settlement could be a better option.
READ MORE: Need help now? Here’s how to get assistance
Other debt relief options
Debt consolidation and debt settlement are not the only debt relief options. If neither seems to meet your needs, consider these possibilities.
- Debt management plans are offered by nonprofit credit counseling agencies. You will make a single monthly payment to the credit counselor, and they will pay your creditors. The agency will negotiate better terms. A debt management program is similar to debt consolidation, but you don’t need good credit.
- A home equity loan or HELOC (home equity line of credit) can be used to consolidate debts. Approval is usually easy, interest rates are low, and the loan terms are long. Be careful: If you can’t repay the loan, you could lose your home.
- Bankruptcy is often treated as a last resort, but if you really can’t pay your loans, it can wipe the slate clean. Consult a bankruptcy lawyer (most offer a free initial consultation) to see if it’s the right option for you.
- Payday Alternative Loans are small installment loans offered by many credit unions as an option to avoid payday loans. Interest rates are capped, and your credit score doesn’t matter.
Pro tip: If you’re looking for debt relief, be careful. There are many scammers out there trying to prey on desperate people. Always check the reputation and credentials of any company offering debt relief, and if you’re suspicious, contact the Federal Trade Commission. If it sounds too good to be true, it’s probably not true!
The bottom line
If your financial situation is overwhelming, you need to take action. The action you take will depend on your specific situation and needs. Debt consolidation and debt settlement are both valid and potentially effective ways to become debt-free. But they are also very different, and they are best used in different situations. Understanding them — and other debt-relief options — will help you to choose the best method for you.
The amount of time a debt settlement will affect your credit score depends on several factors, including the severity of the settlement, the age of the account, and your overall credit history. A settled debt will be noted on your credit report for seven years from the date of the initial delinquency. During this time, it can have a significant impact on your credit score because it indicates that you were not able to pay off your debts in full.
However, the impact on your credit score may diminish over time, particularly if you take steps to improve your credit habits and build a positive credit history.
Your credit score will be lowered by the debt settlement process. It’s possible to get a car loan even with deep subprime credit, but your interest rate will be very high. If possible, take some time to rebuild your credit before shopping for large loans.
It depends. Most credit card issuers will close your account as part of the debt settlement process, so you probably won’t have a credit card to use. If you have a credit card account that wasn’t involved in the settlement process, you may still be able to use that. You can apply for a new one, but the settlement process will damage your credit and reduce your options. You can also consider applying for a secured credit card. If you need to keep an existing card open, settle your other debts and keep making payments on the card you want to keep.