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Debt consolidation vs. debt settlement

Debt consolidation folds multiple debts into one; debt settlement reduces amounts owed

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If you’re looking for an efficient way to climb out of debt, you’re not alone. According to Debt.org, the average American aged 30 to 49 has more than $26,000 in debt (not including mortgages), and delinquency rates for younger borrowers have already surpassed pre-pandemic levels.

Many Americans might be considering either debt consolidation or debt settlement as methods for managing their debt. But how do they work, what are the pros and cons of each, and which one is right for you?

Key insights

  • Debt consolidation rolls multiple debts into a single debt with one interest rate.
  • Many debt consolidation products require good credit.
  • Debt settlement involves negotiating overdue balances with your lenders.
  • Debt settlement can take years and can lower your credit score by over 100 points.

What does debt consolidation mean?

Debt consolidation combines multiple debts into one debt with a single interest rate. This way, you don’t have to worry about paying multiple lenders with varying rates, due dates and minimum payments.

The main advantage of debt consolidation is simplicity: Tracking only one balance means you’re less likely to miss payments and incur fees. Debt consolidation loans also often have lower monthly payments and/or annual percentage rates (APRs) than, say, credit cards.

“You have the opportunity to save money, which could translate to hundreds, if not thousands, of dollars over the life of your loan should you be able to secure a lower APR,” said Christopher Stroup, a certified financial planner with Abacus Wealth Partners.

Still, debt consolidation isn’t always a perfect solution. If you choose a long debt consolidation loan term with a small monthly payment, you might end up paying a lot of money in interest over time.

Also, be aware that the debt consolidation industry is rife with hidden fees and “teaser rates” that ultimately expire. Keep an eye out for any predatory lending practices.

» MORE: How to manage your money

How debt consolidation works

Debt consolidation works by rolling multiple debts into one. The chief benefits of debt consolidation are simplicity, stress relief and possibly a lower overall interest rate. But different debt consolidation products have different benefits and drawbacks.

Debt consolidation loans are personal loans specifically designed to help you consolidate debt. Many banks, credit unions and specialized lenders offer fixed-rate debt consolidation loans. Although some of these lenders might approve applicants with fair or even bad credit, you’ll need good or excellent credit to qualify for the best interest rates.

You might be able to find a debt consolidation loan with a low interest rate, but keep in mind that some lenders offer long loan terms, which can potentially lead to you paying more interest overall than if you were to continue paying off multiple debts in a shorter time frame. However, if the payments are more manageable and can keep you on track toward paying down your debt, the cost may be worth it.

Credit card balance transfers allow you to transfer high-interest debts onto a single, 0% interest credit card. These cards may offer up to 21 months of 0% interest, buying you valuable time to pay off your card without double-digit interest spiraling out of control. That said, these balance transfer promotions typically come with a fee of at least 3% of the transferred balance.
Home equity loans, also known as second mortgages, allow you to take out a loan using the equity in your home as collateral. You can use your home equity loan as a debt consolidation loan by taking the lump sum you receive from your lender and using it to pay off multiple debts.

Because home equity loans are secured by your home, they may come with lower interest rates than unsecured loans. But they’re also risky: If you don’t make your home equity loan payments, the lender might foreclose on your home.

Debt settlement meaning

Debt settlement is the process of asking a lender if you can settle for less than you owe. Most lenders will only consider debt settlement if the account is significantly overdue and you have the cash on hand to settle it.

For example, if you owe your credit card company $10,000 and you recently lost your job, you might be able to negotiate a $5,000 settlement (as long as you have proof that you have $5,000 in cash to give).

The reason a lender would even consider settling for less than what it’s legally owed is quite simple: Something is better than nothing. In the case above, your credit card company gave you an unsecured line of credit, meaning there’s no collateral it can legally repossess (e.g., a car or home) to recoup its losses.

In this case, the card issuer’s options boil down to sending your account to collections and possibly receiving nothing or taking your $5,000 cash offer now. It can be something of a win-win situation for both a borrower and their lender.

“The pros of debt settlement include speeding up the repayment process, reducing the total amount owed and simplifying your repayment plan,” said Stroup. “By negotiating with creditors to settle for less than the full amount, you can quickly lower debt and save money.”

But slashing your bill doesn’t come without risk or consequence. Here are some of the biggest drawbacks to debt settlement:

  • It will almost certainly damage your credit.
  • Third-party debt settlement companies charge high fees (up to 25% of your total debt) to negotiate with your creditors.
  • You’ll owe taxes on the forgiven portion of your debt.
  • The process can take years of negotiating, and there’s no guarantee that a creditor will accept a settlement offer.

So while debt settlement can drastically reduce your debt load, its unpleasant side effects are why it’s often considered a last resort after tactics like debt consolidation, credit counseling and other options have been exhausted.

» MORE: Credit counseling vs. debt settlement

How debt settlement works

Debt settlement involves negotiating with your lender once your accounts are significantly overdue. Some lenders may settle for as little as 50% of your current balance. But you may need to pay cash, and the long-term impact on your credit can be severe.

There are two main ways you can approach a debt settlement: You can try bargaining with your lender yourself, or you can outsource the negotiation to a third-party settlement company.

DIY debt settlement involves opening a dialogue with your lender, explaining your financial situation and proposing a reasonable settlement amount.

While you may not get the same results as a debt settlement attorney or debt settlement company, you can at least save time and fees by attempting to negotiate your debts on your own.

Third-party debt settlement companies, also known as “debt relief companies,” can negotiate with lenders on your behalf, acquire a debt settlement agreement for your approval and set up a payment plan.

Legitimate debt settlement companies will not charge fees upfront and will instead charge a settlement fee, likely between 13% and 25% of the enrolled debt.

Difference between debt consolidation and debt settlement

While they sound similar at first glance, debt consolidation and debt settlement are two very different ways to reduce your debt, and each is suited to different circumstances.

Debt consolidation might be a better fit if you’re just trying to organize your debts in one place and potentially save some money on interest. Debt settlement is often considered a last resort before bankruptcy. In either case, credit counseling may help you choose the best path forward.

Debt consolidationDebt settlement
How it works Multiple debts are rolled into one with a single (ideally fixed) interest rate. A significantly overdue balance is negotiated with the lender.
Target outcome One monthly payment with a low interest rate Reduced balances on one or more debts
Common methods
  • Debt consolidation loans
  • Balance transfers
  • Home equity loans
  • Do-it-yourself negotiation
  • Third-party debt settlement companies
  • Pros It can lower your overall interest rate and may help you avoid missed payments to creditors. You may be able to save thousands, pay off debt sooner and avoid bankruptcy.
  • You may pay more in interest with a long loan term.
  • Decent rates require a 670+ credit score.
  • It can lower your credit score by 100+ points.
  • Debt settlement companies charge high fees.
  • Creditors may deny your offer.
  • Best for Putting all your loans in one place to avoid missed payments Closing significantly overdue accounts

    Other debt management options

    Debt consolidation and debt settlement are just two of many debt-reduction strategies you can implement to effectively manage your debt load.

    • Credit counseling involves working with a counselor through a nonprofit that can help you manage your finances, set up a debt management plan and rebuild your credit. Initial sessions are often free, and the National Foundation for Credit Counseling (NFCC) reports that 73% of consumers it works with are able to pay their debts more consistently.
    • The debt snowball is a simple debt repayment strategy that involves paying off your debts in order of outstanding balance, starting with the smallest. The idea is to clear your small debts quickly, which may give you momentum and motivation to keep going.
    • The debt avalanche is similar to the debt snowball method but involves paying off your debts in order of highest to lowest interest rate. This method may be more efficient and result in paying less interest, but since it can leave your individual loans open for longer, some find it demotivating.

    Keep in mind that these strategies aren’t necessarily mutually exclusive. You may decide to set up a debt snowball while simultaneously negotiating for a debt settlement on your most delinquent loan.

    » MORE: How to get out of debt

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      Does debt consolidation hurt your credit?

      Debt consolidation can temporarily lower your credit score since applying for new credit and paying off an installment loan can both negatively impact your credit. However, making regular, on-time payments toward your debt consolidation product can quickly rebuild your credit.

      How long does a debt consolidation stay on your credit?

      A debt consolidation product will stay on your credit report as long as it’s open. Missed payments will stay on your credit report for seven years.

      What is a settled account?

      A settled account is an account that has either been paid in full or closed.

      How long does debt settlement take?

      The process of negotiating and settling debt typically takes between three and four years, according to the NFCC.

      Can I still use my credit card after debt settlement?

      Once a credit card balance is settled, you cannot use that specific card anymore because the lender will have closed the account. You can, however, continue using your credit card after a debt consolidation (assuming the account is in good standing).

      Bottom line

      Debt consolidation involves rolling your debts into a single balance to simplify your finances, avoid missed payments and possibly reduce your interest rate. Debt settlement involves negotiating down an outstanding balance with its creditor.

      Due to its mixed success rate and severe credit impact, debt settlement is often considered a last resort before declaring bankruptcy. If you’re simply looking to better manage your existing debts, credit counseling and debt consolidation may be the right next steps.

      ConsumerAffairs writers primarily rely on government data, industry experts and original research from other reputable publications to inform their work. Specific sources for this article include:
      1. Debt.org, “Demographics of Debt.” Accessed Sept. 13, 2023.
      2. Consumer Financial Protection Bureau, “What do I need to know about consolidating my credit card debt?” Accessed Sept. 12, 2023.
      3. Experian, “6 Risks of Debt Settlement.” Accessed Sept. 12, 2023.
      4. National Foundation for Credit Counseling, “The NFCC Sharpen Your Financial Focus Initiative Impact Evaluation.” Accessed Sept. 13, 2023.
      5. National Foundation for Credit Counseling, “Which Debt Repayment Method is Right for You? A Closer Look at Debt Settlement.” Accessed Sept. 18, 2023.
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