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Debt Settlement vs. Debt Consolidation: Which is Better?

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 option is best for you.

Our take

  • Debt consolidation will be the better option if you have good to excellent credit scores
  • Debt settlement will be better if you have more than $10,000 in unsecured debt and a low credit score
  • If you already have debt in collections or charged-off debts, debt settlement will be better
  • If you aren’t sure which is best for you, schedule a free consultation with a debt settlement company to discuss your options

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What’s the difference?

Debt settlement and debt consolidation are two fundamentally different approaches to tackling debt.

  • Debt settlement (also called debt resolution) 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 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 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 settlementDebt consolidation
How it worksYou, 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 debtVirtually 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 optionYou 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 benefitYou 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 benefitsAvoid 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 disadvantageYou will have to temporarily stop paying certain debts, so you likely will get calls from debt collectorsThis will only work if your credit score is high enough to qualify for new credit
Other disadvantagesFees
IRS implications
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 scoreHigh: 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 implicationsThe forgiven debt may be considered taxable incomeNone
Payment structureOnce you reach a settlement agreement, you can either make one lump-sum payment or agree on a series of payments over a specific loan termOne 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 youYou 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

READ MORE: When is debt settlement a good idea?

Debt settlement options

If you’re considering 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 27%. You will pay this after the debts are settled.

According to the American Association for Debt Resolution, the average debt settlement customer reduces their debt burden by 30%, including fees, if they complete the debt settlement program. Lack of ability to save enough to pay the settlements is the most common reason for a debt settlement plan to fail.

READ MORE: Debt settlement companies

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 to show the creditor that you can afford to make the payments on your settled debts, whether in a lump sum or as a payment plan.
  • Negotiate with your creditors. You’ll need to initiate contact with your creditor or the debt collector, reach an individual with authority to negotiate and persuade that individual to accept a settlement.

READ MORE: How does debt settlement work

Pro tip: This isn’t easy, but if you have the discipline to save money and the knowledge and confidence to negotiate on your own, 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. DIY may be your only option if your unsecured debts are below this level.

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:

Loans

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 must have a good credit score and a low debt-to-income ratio to get the best terms on a debt consolidation loan.

Plenty of loan options exist, 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 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 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.

READ MORE: Debt relief programs

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.

READ MORE: How will debt settlement impact your credit score?

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 legitimate and potentially effective ways to become debt-free. But they are also very different and best used in different situations. Understanding them — and other debt-relief options — will help you to choose the best method for you.

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