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?
How Does Debt Settlement Work?
You, or a representative negotiating for you, make an offer to your creditor to settle the debt for less than what is owed. For example, if you owed $10,000, you might offer the creditor a lump-sum payment of $5,000.
If the creditor accepts the offer, you make the payment and the matter seemingly is settled.
We say seemingly, because if you owe more than one creditor, as is often the case, you must go through the process with each one. So, if you are delinquent on several credit cards or bills (e.g. cable, cell phone, medical, etc.), you will have to negotiate a settlement with each one before you are out of debt.
In the meantime, you likely will be racking up costly late fees and interest charges on all your debts. In the case of debt settlement pros and cons, this is just one of the many cons associated that make it a dicey choice.
Debt Settlement: Pros and Cons
The prospect of paying less than you owe — far less in some cases — makes debt settlement an enticing choice for eliminating debt.
It is also a risky one, a debt relief option so fraught with misunderstanding and negatives that most financial experts would recommend it only as a last resort.
Disadvantages of Debt Settlement
- Additional Late Fees – Debt settlement companies often encourage you to stop making payments to your creditors while they negotiate a settlement. The late fees, interest and other penalties that follow will be added to the amount you owe already.
- Time Frame – The normal time frame for a debt settlement case is 2–3 years, which means 24–36 months of late fees and penalties added to the amount you owe.
- Impact on Credit Score – Debt settlement will have a negative impact on your credit score. Not paying the full amount is a negative. Missing payments while negotiating a settlement is a negative.
- Impact on Credit Report – The fact that you settled your debt — that is, didn’t pay the full amount — remains on your credit report history for seven years, making it more difficult for you to get credit from any lenders.
- Companies Charge Fees – Debt settlement companies charge a fee, which is usually a percentage of the amount owed, to negotiate on your behalf. The fees generally are 20–25% of the final settlement, so if your final settlement is $5,000, you could owe another $1,000 to $1,250 in fees.
- Lenders May Refuse – Lenders are not obligated to accept settlement offers. In fact, some lenders refuse to work with debt settlement companies.
- Tax Consequences – There could be tax consequences from a debt settlement. The IRS may count whatever amount is forgiven as income and require you to list it on your taxes.
Is Debt Settlement Worth It?
With so many negatives attached to the outcome, many consumers wonder: Does debt settlement really work?
For people who feel helpless with their financial situation and don’t want to declare bankruptcy, debt settlement could be the short-term answer. If you can put together enough money quickly enough to make a good lump-sum offer to your creditor, this is a way out of trouble.
However, if you think you will need credit in the future to purchase a home, car or other big-ticket item, this might not be the best option. It’s a considerable stain on your credit report and will stay there for seven years.
Debt Consolidation: Pros and Cons
If you are overwhelmed by the sheer volume of bills arriving at your home every month, debt consolidation may be the debt-relief program you need, but only if you’re able to curb your enthusiasm for spending.
Credit cards are the source of most financial problems for consumers. The average American family has 3.7 credit cards and owes $5,700 in credit card debt. Throw in bills for rent, cable, cell phone, utilities and on and on, and that’s a lot of accounting to keep up with every month.
If you fall behind on one credit card, it can be an uphill struggle to catch up. When it reaches the point where you’re only making minimum payments on one or more of the bills, then it’s time to consider debt consolidation.
Pros for Debt Consolidation
The pros for debt consolidation are obvious:
- You are simplifying the process of paying your bills. You make one payment to one lender with one deadline every month in place of multiple payments to multiple creditors with multiple deadlines.
- You should be paying lower interest rates. If you fall behind on credit card payments, card companies typically raise the interest on your account to somewhere in 25%-30% range, sometimes higher. Debt consolidation loans can be had for somewhere between 8%-15% in most cases.
- Paying off all your credit cards should improve your credit score, provided you don’t use cards the way you once did.
Cons for Debt Consolidation
The cons to debt consolidation are just as obvious:
- The debt is not forgiven or even reduced. You still owe the same amount of money and if you don’t d decrease your spending the problem will never go away.
- Getting an effective debt consolidation requires a good credit score. If you have a poor credit score, you might be denied a debt consolidation loan, or the interest rate on the loan might be the same as the interest rate on your credit cards.
- Time can also be an issue. You should be prepared to spend anywhere from 2–5 years in a debt consolidation program before eliminating the debt.
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?
There are four major types of debt consolidation:
- Debt management plan (DMP)
- Balance transfer on credit cards
- Personal loans
- Home equity loan or line of credit
A debt management program 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. 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.
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.
Debt Relief vs. Bankruptcy
Bankruptcy might be the most feared word in the financial dictionary. It also might be the only way out of trouble for people drowning in debt.
If you tried debt settlement and debt consolidation, and neither is able to eliminate your debt in less than five years, bankruptcy is a viable alternative. In fact, if you’ve deemed your situation “hopeless” it might even be prudent to look into bankruptcy sooner rather than later.
The bankruptcy laws were written to give people a fresh start, especially those whose financial troubles were not the result of careless spending, but something unexpected like loss of a job, a divorce, or a catastrophic illness resulting in massive medical bills. Filing for bankruptcy could stop foreclosures, wage garnishing and debt collection activity, while getting rid of unsecured debts.
There are several types of bankruptcy, but the two most popular ones are Chapter 7 and Chapter 13. In Chapter 7, certain assets are considered exempt — home, automobile, retirement savings, some tools and some home furnishings — but all others are liquidated and the funds used to pay your creditors.
Chapter 13 bankruptcy gives you a chance to reorganize your finances and come up with a plan to repay all or most of your debt in a time frame of 3–5 years.
Unlike debt settlement and debt consolidation, bankruptcy typically wipes out all unsecured debt. Although this may seem like a solution to your money problems, it will have lasting consequences on your credit report. Bankruptcy remains on your credit report for 10 years.
It’s difficult to compare debt settlement or debt consolidation vs. bankruptcy, because many state and federal laws that apply to bankruptcy don’t apply to the other two forms of debt relief. However, it is safe to say that while bankruptcy is a course of last resort, it is still an option worth considering if you’re ready to start over financially.
About The Author
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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