What’s the Difference Between Debt Consolidation and Debt Settlement?

If you’re struggling with debt, you’re not alone. Total household debt shot up to $17.80 trillion as of the second quarter of 2024. So how do you deal with overwhelming debt? We’ll compare two of the most common strategies: debt consolidation vs. debt settlement. Understanding the steps, pros and cons of each can help you make an informed decision about which process best suits your financial goals.

What Is Debt Settlement?

With debt settlement, you negotiate with creditors to reduce how much you owe. A third party, such as a debt settlement company, also can negotiate for you. If the creditor accepts the debt settlement plan, your remaining debt is forgiven, and they can’t collect on it. 

Here’s how debt settlement works and the process involved:

• The first step is to look at your finances and assess your eligibility. You can’t settle debt for mortgages or auto loans. Instead, they’re used for unsecured debt such as credit cards, medical bills and personal loans. From there, you can review the debt settlement policies of the relevant creditors.
• Next is the negotiation phase. During this phase, you can contact creditors on your own to make an offer or use a debt settlement company like National Debt Relief. A debt settlement company will typically charge a fee of 15 to 25% of what you owe, which they can collect once they settle your debt. And the process can take a long time, regardless if you use a company or not.
• You start paying off the settled amount once you reach an agreement. 

What Is Debt Consolidation?

Debt consolidation involves combining multiple debts into a new loan or credit card. This allows you to roll your debts into one loan that may have lower interest rates than your original debts. 

Here’s how debt consolidation works and the process involved:

• You apply for a new personal loan, credit card or home equity loan. 
• You use the consolidation loan to pay off your existing debt. For example, if you apply for a credit card with a balance transfer option, you can transfer the balances from your current cards onto the new one and then make payments. Balance transfer cards often offer more favorable terms for a certain amount of time or even a 0% interest rate. 
• You make a single monthly payment until you clear the debt.

Debt Consolidation vs. Debt Settlement: Key Differences

Though they both can potentially ease the burden of debt, there are key differences when you compare debt consolidation vs. debt settlement. Let’s review a detailed comparison of the process, impact on credit score, cost and the time required. 

1. Process:
   • Debt Settlement: You negotiate with creditors directly or through a debt settlement company to reduce the total amount you owe. If you reach a settlement, youl pay a lump sum amount that is less than your total debt. 
   • Debt Consolidation: Multiple debts are combined into a single loan that typically has lower interest rates. Your loan is consolidated into a single monthly payment.
2. Impact on Credit Score:
   • Debt Settlement: A debt settlement agreement will add a delinquency to your credit report. Any delinquent account and debt charged off by creditors will remain on your credit report for up to seven years.
   • Debt Consolidation: You may experience a minor hit on your credit score when you take out the consolidation loan. Overall, you’ll experience a less negative impact on your credit than with debt settlement as long as you make timely payments. 
3. Cost:
   • Debt Settlement: Companies charge fees of 15 to 25% of the debt you owe. You may also face a setup fee when you open a dedicated escrow account, a monthly fee to maintain the account and tax implications on the forgiven debt.  
   • Debt Consolidation: You may have fees or loan on the balance transfer as well as interest. 
4. Time Required:
   • Debt Settlement: Negotiations with creditors can take months or even years and are not always successful.
   • Debt Consolidation: This process is much faster and ranges from a day to a few weeks as lenders review your creditworthiness.

Pros and Cons of Debt Settlement

Considering pursuing debt settlement? Review the pros and cons first. 

Pros:

• Reduced debt: If the debt settlement process is successful, you’ll pay less than you owe. 
• Relief from collections: Creditors will stop collections once they receive the lump sum payment.

Cons:

• Credit score impact: This process will impact your credit score, which can make it harder to get a favorable loan or a loan at all in the future. 
• Tax implications: The IRS can consider forgiven debt taxable income.
• Fees: Debt settlement companies often charge fees for their services, and there are escrow and setup fees to consider as well. 

So, is debt settlement right for you? It might be if you’re facing a large amount of debt and can’t make minimum payments. You can reduce your overall debt burden and get relief from creditors if it’s successful. Just know your credit will take a hit, and there are tax implications to consider. 

Pros and Cons of Debt Consolidation

Thinking debt consolidation might be a better fit for your needs? Check out the advantages and disadvantages of taking this route. 

Pros:

• Single monthly payment: Consolidating multiple debts in one monthly payment is easier to manage. 
• Potential lower interest rates: You may secure a lower interest rate and/or more favorable terms than your previous debts.
• Credit score impact: You’ll experience less negative impact on your credit score than with a debt settlement.

Cons:

• Full amount of debt: Unlike with a debt settlement, you’ll still owe the full amount of the loan, which can rack up with interest fees. 
• Risk to collateral: If you receive a secured loan, you’ll put assets at risk if you default on the loan. 

Debt consolidation may be a good option if you want to simplify your payments and get a lower interest rate. You’ll still owe the full amount, but if you get a lower interest rate, you’ll pay less interest over time and simplify your debt.

Choosing the Right Option for You

As you look at debt consolidation vs. debt settlement, start by assessing your financial situation. Your total debt, income and expenses can help you determine whether debt settlement or debt consolidation is a better option. Consider whether you can manage a single monthly payment or need a major reduction in debt. 

Don’t forget about the impact on your credit and any long-term financial or tax implication. Finally, it’s worth it to seek out the professional opinion of a financial advisor or credit counselor to determine the best path forward.