Debt Settlement vs. Debt Consolidation

Debt settlement and debt consolidation are often confused with each other, but are two vastly different solutions for consumers struggling with credit card debt.

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Learn the difference between Debt Management and Settlement

Debt settlement and debt consolidation share a common goal – help consumers find a way out of credit card debt – but take very different routes to achieve that goal.

Debt settlement is negotiating with creditors to settle a debt for less than what is owed. This method is most often used to settle a substantial debt with a single creditor, but can be used to deal with multiple creditors.

Debt consolidation is an effort to combine debts from several creditors, then take out a single loan to pay them all, hopefully at a reduced interest rate and lower monthly payment. This is typically done by consumers trying to keep up with bills for multiple credit cards and other unsecured debts.

The pros and cons of debt settlement and debt consolidation vary, especially with regard to the amount of time it will take to eliminate debts and the impact it will have on your credit score. When used properly, either can help you get out of debt sooner and save money.

So which option is best for you?

What Are the Differences Between Debt Settlement and Debt Consolidation?

For someone struggling to manage debt, consolidating and settling debt might seem like equally good solutions. It’s important to note, however, that these two options are vastly different, with one being far riskier than the other.

Debt settlement is a for-profit industry, made up of companies that claim to settle customers’ debt for less than the full amount that’s owed. Sometimes called “debt relief,” these companies work by taking over management of their clients’ debt accounts, collecting monthly payments from the customer, and eventually offering funds to their creditors as lump-sum settlements.

For customers of debt settlement companies, this process can eventually result in some savings, but it also will damage their credit, result in major late fees and interest charges, and put them at risk of being sued by creditors.

While it has a similar name, debt consolidation works very differently than debt settlement. Debt consolidation refers to a set of financial products — including loans and credit cards — that can be used to pay off multiple debts and roll them into one new account.

Debt consolidation products each come with unique rates and fees, as well as requirements to qualify, but the result of debt consolidation should ideally be reduced interest rates; more affordable monthly payments; and more manageable terms for the borrower.

How Does Debt Settlement Work?

Working with a debt settlement company can be a long and involved process. These are the steps that are generally required:

  1. Set up an account: Each company requires different agreements to get started, but you may have to sign a power of attorney, set up a new bank account and agree to cease contact with your creditors.
  2. Send monthly payments: The debt settlement company will collect your payments and set them aside, often for a duration of 3 years or more. In the meantime, money will not be sent to your creditors. By withholding payment, the debt settlement company attempts to make a lump-sum settlement offer more enticing to creditors. Note that your creditors will likely continue contacting you throughout this period.
  3. Make settlement offers: You, or a representative negotiating for you, will make an offer to each of your creditors to settle the debt for less than what is owed. For example, if you owe $10,000, you might offer a lump-sum payment of $5,000. The creditor may or may not accept.

At the end of this process, you may still owe some debt, plus newly accrued fees, to creditors who refused to accept a settlement. See our list of pros and cons below for other common outcomes.

Negotiating a Debt Settlement

If you’re struggling with debt payments, one alternative is to settle debt on your own. In fact, working directly with your creditors to negotiate a settlement can get you the same results as working with a for-profit company, but with fewer fees and far less risk.

Here’s how you can go about settling debt on your own:

  1. Save money for an offer: Set cash aside that you can eventually offer as a lump-sum payment. Many creditors won’t accept less than 50% of the total balance you owe.
  2. Negotiate your payment: Contact your creditor to negotiate a settlement amount. Start with a low offer and, if possible, avoid setting up a new payment arrangement as this can lead to new fees and more credit damage.
  3. Ask for an update to your credit report: As part of your negotiations, ask the creditor to update your account status to “paid in full,” on your credit reports once they receive your payment. While this won’t improve your credit scores, it can make it easier to get approved for mortgages or credit down the line.
  4. Get it in writing: Request documentation of your agreement. Make sure it states that your settlement will be accepted as “payment in full,” and that the creditor or debt collector will update your credit reports.
  5. Send payment (safely): Send a traceable form of payment that isn’t linked to your personal accounts, such as a cashier’s check sent by certified mail.

Tips: If your debt has passed the Statute of Limitations, you may not have a legal obligation to pay it back. This legal time frame is different in each state. Additionally, most unpaid debt will be removed from your credit reports after seven years of non-payment. We recommend speaking to a professional at a nonprofit credit counseling agency if you need guidance navigating these timelines.

Debt Settlement: Pros and Cons

The prospect of paying less than you owe — far less in some cases — makes debt settlement an enticing option. But it’s also one of the riskiest ways to get debt relief, so consumers should carefully consider the pros and cons and treat debt settlement as a last resort.

Pros of Debt Settlement

If you work with a debt settlement company that’s accredited through the American Fair Credit Council (AFCC) and the Better Business Bureau, you might experience some of these benefits:

  • Potential savings: There’s no guarantee that your creditors will accept settlements, but some creditors may accept a lump sum for as little as 50% of what you owe. After paying your late fees, interest charges, and the fees charged by a debt settlement agency, you may end up saving money.
  • You may pay off debt faster: The process of debt settlement often takes three or more years to complete, but for some debtors this could be a faster path to becoming debt free than paying off their full debt balances.

Cons of Debt Settlement

There’s a reason the Federal Trade Commission, the Consumer Financial Protection Bureau and the National Foundation for Credit Counseling all caution consumers against the risks of dealing with for-profit debt settlement. These are the main drawbacks:

  • Late fees: When you stop sending payments to your creditors, you’ll begin accruing late fees, interest charges and other penalties.
  • Time commitment: The normal time frame for a debt settlement case is two to three years. Many customers are unable to sustain their payments and end up dropping out of their debt settlement program before they’ve sent enough money to get all of their debts settled.
  • Damaged credit: Debt settlement can damage your credit score just as much as filing bankruptcy. In fact, missing just one debt payment while negotiating a settlement can cause you to lose as much as 100 points or more from your credit scores, and settled debts will not be automatically removed from your credit reports.
  • Settlement fees: Debt settlement companies typically charge a fee of 20%-25% of the final settlement amount. So, if your final settlement is $5,000, you could owe another $1,000 to $1,250 in fees. You’ll also be charged fees on your savings account.
  • Creditors may refuse: Creditors are not obligated to accept settlement offers. In fact, some even refuse to work with debt settlement companies.
  • Tax consequences: There could be tax consequences from debt settlement since the IRS requires you to report forgiven debt of $600 or more as taxable income.
  • Legal consequences: Once creditors become aware that you don’t intend to repay your full debt, they may choose to sue you for the money and could potentially garnish your wages or freeze your bank accounts.
  • Risk of scams: Financial scams and predatory loopholes are rampant in the debt settlement industry. For example, if you enroll in-person or online, you can legally be charged fees before your debt is settled. Some companies also use false advertising, like guaranteeing they can settle your debt for as little as a third of what you owe.

How Does Debt Consolidation Work?

Debt consolidation is another option for managing debt. With debt consolidation, you’ll open a new loan or balance transfer credit card and use it to pay off existing debts. In doing so, you may be able to reduce your total interest charges or otherwise make your debt payments more manageable.

Here are the basic steps:

  1. Shop for a new credit card or loan: Depending on your credit rating, you may have a variety of options. Be sure to compare rates and fees, including any fees for transferring your debt to the new account. Note that loans generally offer much lower interest rates than credit cards.
  2. Apply: Each creditor has its own application requirements, but some may offer you a quote based on a snapshot of your credit, income and debts, without any impact to your credit score.
  3. Pay off your debt: Some lenders allow you to have the loan funds sent directly to your old creditors. If not, or if you’re using a balance transfer credit card, you’ll need to manually pay off your debts once your new account is open.
  4. Make payments on your new account: Remember that debt consolidation does not erase debt, it simply restructures it. Once you pay off old accounts, you’ll need to make payments to your new debt consolidation loan or credit card.

Debt Consolidation: Pros and Cons

As household credit card debt increases, many consumers may be looking for ways to manage their outstanding balances. While debt consolidation does not erase debt, it can help you manage your debt more effectively.

Pros for Debt Consolidation

  • Fewer accounts to manage: Consolidating debt means reducing the number of payments you have to make each month, the due dates you have you keep track of and more. By consolidation, you could potentially roll several accounts into one and streamline them all into a single payment.
  • Potential savings: If your credit scores have improved, or if the market has shifted, you may be able to get lower interest rates on a new account and reduce your overall cost of debt repayment. Using a loan to pay off credit card debt can be a big help, for example. since the average credit card interest rate is around 17%, but rates on debt consolidation loans are often much lower.
  • Budget relief: Consolidation could reduce your total monthly debt bill. For example, if you take out a loan with a long repayment time frame, you can spread out your payments and reduce your monthly amount due. While a longer repayment time frame means accruing more interest charges, it might be the only solution for someone struggling to cover their monthly bills.

Cons for Debt Consolidation

  • Delaying the inevitable: Consolidation can make debt payment more affordable, but it doesn’t make your debt go away. Moving balances around may feel like a solution to your anxiety about debt, but you’ll still be responsible for making full repayments.
  • Credit can be an obstacle: Getting the best debt consolidation products requires good credit scores. If you have poor credit, you might be denied a debt consolidation loan, or the interest rate might be the same as the interest rate you’re paying on credit cards.
  • Fees: If you’re not careful, the fees for your new account could undermine your goal. Be sure to keep an eye out for origination fees, application fees, transfer fees, and of course high interest rates.

Types of Debt Consolidation

If you decide to consolidate your debts, another decision has to be made: What type of debt consolidation program should I use?

The best ways to consolidate debt are:

A debt management plan is a popular choice because it typically includes credit counseling and education programs to help you to identify the causes of your financial problems. Credit counselors also can provide solutions that you can take with you after completing the program. The downside on DMPs is that they usually take 3–5 years to eliminate the debt and some people aren’t patient enough to stick with the program that long.

Balance transfers, often referred to as 0% balance transfers, are extremely attractive offers by credit card companies, but usually are limited to consumers with excellent credit scores. They can be used for credit card consolidation or refinancing, but if your credit score isn’t somewhere above 700, you probably won’t qualify. Also, there normally is a transfer fee involved (2–3% of the balance being transferred) and an expiration date (usually 12–18 months) on the 0% interest rate.

Numerous sources offer personal loan options — most often a bank, credit union, or online lender. The interest rates vary, but usually are fixed at rates less than what is paid on credit cards. However, most personal loans include an origination fee, some include a pre-payment penalty, and others require collateral (e.g. a home or car). Qualifying for a personal loan with a low credit score can be difficult, especially if your debt-to-income ratio is high. Look into online and peer-to-peer lending websites like Lending Club.

Home equity lines of credit also carry relatively low interest rates, but your home serves as collateral and could be lost if you fail to make payments. Application fees and closing costs also could be involved.

It’s possible, though not advisable, to borrow from your 401(k) account to consolidate debts. The restrictions and impact on your retirement account make this a very low-reward choice.

If you are trying to pay off student loans, there are many options available for consolidating federal student loan debt. Most of the consolidation programs are based on what you’re earning, which can ease the monthly payment due.

When you examine each method, it is important to come up with the total cost of bill consolidation, the amount of time the process will take and what impact, if any, it will have on your credit score.

Bankruptcy as an Alternative to Debt Consolidation and Settlement

Bankruptcy is often considered a last-ditch effort for people who have looked into every other option. Filing bankruptcy can be a difficult and stressful process, one that causes major damage to your credit, but it may be the right choice for someone who has no means to pay off their debt within the next five years.

Bankruptcy laws were written to give people a fresh start, especially those with unpreventable financial hardships, like the loss of a job, the death of a loved one, or a chronic illness.

When comparing debt settlement to bankruptcy, the upsides include that bankruptcy can involve debt cancellation and it can halt foreclosure proceedings, wage garnishments and debt collection activity.

There are several types of bankruptcy, but these are the two most common options for consumers:

  • Chapter 7 debt forgiveness generally takes four to six month to complete, and will remain on your credit reports for 10 years after you file.
  • Chapter 13 debt repayment can give you an affordable repayment plan that takes three to five years to complete. Once you file, the bankruptcy will stay on your credit reports for seven years.

Note that there are many debts that cannot be included in bankruptcy, including student loans, most tax bills, child support and alimony.

Tip: Bankruptcy has a major negative effect on your credit, but the damage is not permanent. Over time the impact will lessen, and with good credit habits you can recover over the course of as little as two to three years.

» Learn more: How Does Debt Relief Work?

How Can I Get Help Exploring My Debt Relief Options?

Debt settlement and debt consolidation aren’t the only solutions. Given all of the different options for tackling debt, It can be difficult to make a choice. Fortunately, some of the best guidance is available from professionals, free of charge.

A certified credit counselor from a nonprofit credit counseling agency can help you review all of your options, from making budget adjustments to filing bankruptcy. They can also walk you through the ins-and-outs of a debt management plan ,.which includes working with multiple creditors to set up one affordable monthly payment.

About The Author

Bill Fay

Bill “No Pay” Fay has lived a meager financial existence his entire life. He started writing/bragging about it in 2012, helping birth Debt.org into existence as the site’s original “Frugal Man.” Prior to that, he spent more than 30 years covering the high finance world of college and professional sports for major publications, including the Associated Press, New York Times and Sports Illustrated. His interest in sports has waned some, but he is as passionate as ever about not reaching for his wallet. Bill can be reached at [email protected].

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