You need help with your debt. And after some research, you’ve come across two popular choices: debt consolidation and debt settlement. But which is right for you? Both have their advantages and disadvantages, so it depends on your specific situation.
Keep reading to learn everything you need to know about debt consolidation vs. debt settlement so you can make an informed decision.
When Do You Need Debt Solutions?
Many Americans have debt. In 2024, the average American held $105,056 in debt across mortgages, auto loans, car loans, credit card debt, and more. If you’re making progress paying down your debt while still living comfortably, that debt may feel like just an annoyance.
But, if you can’t keep afloat between living costs and debt repayments, and you’re just watching your debt climb higher and higher, you need to find a new solution. That’s where debt solutions come in.
If your debt has become overwhelming and unmanageable, you likely need a new way to escape your financial problem. The most popular options you’ll come across are debt consolidation and debt settlement.
What is Debt Consolidation?
Debt consolidation is the practice of merging multiple debts into one single loan. You can do this by taking out a debt consolidation loan for all your outstanding debts, paying off your many creditors, and having only one large loan left to contend with. This new loan usually has a fixed interest rate with fixed monthly payments.
Many debt consolidation lenders will pay off your other creditors directly, so you’re not tempted to spend the sudden influx of cash.
Debt consolidation can be done through loans and balance transfer cards (for credit card debt).
Benefits and Drawbacks of Debt Consolidation
The advantages of debt consolidation are:
- Potentially lower APR: You may get a lower interest rate than all (or most) of your previous debts.
- Easier payments: Since you only have one loan to worry about, you also have only one payment, which makes paying on time easier.
- Simple budgeting: Having one loan payment makes budgeting much more straightforward.
- Lower payments: If you were previously unable to keep up with all your debt payments, you could make your new consolidated loan have a lower, manageable monthly payment.
- Track progress: When you have multiple debts you’re trying to pay off simultaneously, it can be hard to track your progress. Without seeing the impact you’re making, you might give up on debt repayment. Having a single loan makes it easy to see the total balance going down.
- Credit improvement: As you make regular, on-time payments on your new consolidation loan, your credit score may improve.
The disadvantages of debt consolidation are:
- Temporary credit score decrease: A debt consolidation loan is a new loan, so you might see a temporary slight dip in your credit after you apply.
- Qualifications: Individuals with poor credit may not qualify for a debt consolidation loan.
- Fees: Debt consolidation isn’t free. The amount you’ll pay depends on the type of debt consolidation and your credit.
- Balance Transfer: If you use a balance transfer card, you can expect to pay a one-time fee of between 3-5% of the total balance. Many of these cards offer a 0% interest rate for a specific period. After that, your interest rate might skyrocket to be the same or higher than your previous credit card’s APR.
- Loan: Debt consolidation loans usually charge an interest rate between 6% and 36%, depending on your credit.
What is Debt Settlement?
A debt settlement is different from debt consolidation, it’s when you come to an agreement with your creditors about paying your debt, usually for less than the outstanding balance. Debt settlement typically only works with lenders where you’ve stopped making payments. In an effort to get their money back, the lenders may agree to a lower repayment amount to avoid writing off your entire account.
Debt settlements are often done through a debt settlement company. This organization will communicate with and negotiate with the lenders on your behalf. Usually, debt settlement companies advise you to immediately stop repaying your debts and start putting the money aside in a bank account. Then, you can offer your lenders a large lump sum payment to get them to commit to a new repayment amount.
Benefits and Drawbacks of Debt Settlement
The advantages of a debt settlement are:
- You pay less: You get your creditor(s) to agree to accept a lower amount than what you owe. Depending on the lender, you may pay as little as 50% of your original outstanding balance.
- All credit scores are welcome: Credit scores aren’t relevant to debt settlement, so even if you have poor credit, this is an option.
Some of the disadvantages of debt settlement are:
- Fees: A debt settlement company charges a high fee, usually between 15-25% of the total debt you originally owe.
- Taxes: The IRS counts the savings from debt settlement as income tax, which means you owe more taxes.
- Credit damage: Debt settlement can cause long-standing damage to your credit. First, you’ll harm your credit score by skipping many payments (while you choose to put the money aside instead). And, if the debt is settled successfully, your report will still reflect that you paid less than what was owed.
- Time: Most debt settlements take two to three years, from negotiation to finished repayments.
- Late fees: When you’re withholding payments in the early stages of debt settlement, you’ll incur fees and penalties, which will add to your total outstanding debt.
- Unwilling lenders: Lenders are under no obligation to accept a debt settlement. You may have gone through withholding payments and incurring penalties only to find out they won’t settle with you.
- Legal issues: When a lender realizes you don’t intend to pay them your total balance, they may choose to sue you rather than participate in a settlement process. A successful lawsuit can lead to garnished wages or frozen bank accounts.
Debt Consolidation vs. Debt Settlement: Which Makes the Most Sense?
So, should you pursue debt consolidation or debt settlement? Generally speaking, debt consolidation has fewer drawbacks. In fact, you’ll likely learn good financial habits and improve your score with a debt consolidation loan.
However, debt consolidation isn’t for everyone. Most importantly, it’s not an option for some because their credit is too low. You have to qualify for balance transfer cards and consolidation loans.
Additionally, it’s not a viable option if you don’t believe you can stick to repaying your debt consolidation loan.
Those with poor credit who are already extremely behind on payments and have lenders who are threatening to sue will likely find debt settlement the more appealing option.
Whatever you do, the most important thing is to take action. Debt doesn’t go away if it’s ignored. Choose an option and start down that path. You can take back your finances; you just have to start today.
You might also be interested in: The Psychological Effects of Debt and How to Cope
