By Ben LuthiDebt Consolidation vs. Debt Settlement: Which Is Better?
Quick Answer
Debt consolidation involves taking out a new loan or credit card to pay off one or more existing debts, ideally at a lower interest rate. Debt settlement, on the other hand, is when you hire a company to negotiate your debt and pay less than you owe.
Debt consolidation and debt settlement are two options you have when deciding how to manage your debt. However, these processes can vary significantly in terms of the potential impact on your credit and financial situation. Understanding how both work, as well as the alternatives, can help you determine what move is right for you.
If you're thinking about pursuing debt consolidation or debt settlement, here's what you need to know about how each option works.
Debt Consolidation vs. Debt Settlement
| Debt Consolidation | Debt Settlement | |
|---|---|---|
| Process | Consolidate one or more high-interest debts with a lower-interest loan or credit card | Negotiate with individual creditors to pay less than what you owe |
| Credit score requirement | Usually good or excellent credit | None |
| Costs | Interest and origination fees or balance transfer fees | Debt settlement company fees |
| Financial impact | Can reduce interest and payments, and possibly help you pay down debt faster | Reduces the amount you need to pay to satisfy a debt; forgiven debt may result in a tax bill |
| Credit score impact | Might hurt credit initially but can improve your score over time | Can cause significant and long-lasting damage to your credit |
Although debt consolidation and debt settlement are both viable ways to tackle your debt, they're very different in their execution and results.
With debt consolidation, for example, the primary goal is to lower your interest rate, helping you save money as you work to pay off what you owe. In some cases, it can also lower your monthly payment and help you pay off your debt more quickly.
Debt consolidation is better suited for people with higher credit scores who can qualify for favorable terms on a new loan or credit card. While your credit score may suffer initially due to the hard inquiry associated with applying for a new account, the impact is usually temporary in nature, especially if you pay your bills on time.
In contrast, debt settlement involves negotiating with your creditors to pay less than what you owe, usually with a lump-sum payment. It may be best suited for people who have fallen behind on payments and want to avoid bankruptcy.
Debt settlement can damage your credit score, but many who may be considering it might already have lower credit scores due to missed payments, defaults and collection accounts. In this case, debt consolidation may not be an option.
What Is Debt Consolidation?
Debt consolidation is the process of borrowing money to pay off high-interest debt, such as credit card balances, medical bills and other loans.
The primary objective of consolidation is usually to secure a lower interest rate, which can save you money. However, the process can also simplify your monthly payments, lower your bills and potentially help you become debt-free sooner.
There are several different ways you can consolidate debt:
- Debt consolidation loan: This is a personal loan used to consolidate debt. Personal loans typically have lower interest rates than credit cards, and they offer structured repayment terms, which can range from one to seven years.
- Balance transfer credit card: Balance transfer credit cards can offer a low or 0% introductory APR promotion, which can last up to 21 months.
- Home equity loan: If you're a homeowner, a home equity loan allows you to tap some of your equity to pay down debt. Interest rates are generally low and fixed, and repayment terms are flexible. If you fail to repay the debt, however, you could lose your home.
- Home equity line of credit (HELOC): Like a home equity loan, a HELOC can allow you to tap some of the equity in your home. However, a HELOC functions more like a credit card, charging interest only on the amount you borrow, up to your credit limit. If you default on your payments, though, you may face foreclosure.
Pros and Cons of Debt Consolidation
Pros of Debt Consolidation
-
Potential savings: If you can qualify for a loan or credit card with a lower interest rate, you could potentially save hundreds of dollars on interest charges. It could also reduce your monthly payment and give your budget more breathing room.
-
Simpler payments: If you consolidate multiple debts, you'll have just one monthly payment to keep track of instead of several.
-
More structure: If you're struggling with the flexible repayment options of a credit card—a low minimum payment and no set repayment term—consolidating your credit card debt with a loan gives you a set timeline for becoming debt-free.
Cons of Debt Consolidation
-
Generally requires good credit: While personal loans don't have a universal minimum credit score requirement, you typically need to have a good credit score to secure an interest rate that's low enough to make consolidation worthwhile. Additionally, most balance transfer credit cards require good credit to get approved.
-
Potential upfront costs: Regardless of which consolidation option you choose, you may face certain costs. Depending on what you choose, it may come in the form of an upfront origination fee, a balance transfer fee or closing costs. These costs can eat into your savings, so it's important to include them in your calculations.
-
Results aren't guaranteed: Even if you have solid credit, there's no guarantee that you can get the terms you need to consolidate your debt and save money. What's more, while debt consolidation can help make your payoff plan more effective, it won't stop you from accumulating more debt.
What Is Debt Settlement?
Debt settlement involves negotiating with your creditors to pay off your debts for less than what you owe. You can opt to try to negotiate on your own, or you can hire a company to negotiate on your behalf.
Either way, debt settlement often requires that you withhold payments to your creditors, which you can use as leverage to negotiate a settlement. It may also be necessary to build up enough savings to cover the settlement amount.
Once you and your creditor agree to a settlement and you pay what you owe, the debt will be satisfied.
Pros and Cons of Debt Settlement
Pros of Debt Settlement
-
Can help you save money: Depending on the situation, debt settlement could erase thousands of dollars based on your original amount owed.
-
May provide short-term payment relief: Withholding payments may give your budget a little breathing room at the start. While you'll need to start saving up for the settlement amount, you may have three to four years to build up your savings.
-
May help you avoid other consequences: If you're behind on your payments and choose not to try to settle, you may face other consequences, such as bankruptcy or even a lawsuit.
Cons of Debt Settlement
-
Credit score damage: Withholding payments can result in late payments and possibly even a default on your credit report. Even if the settlement is successful, it will be noted on your credit report that the account was settled for less than originally agreed. All of these derogatory marks on your report can lower your score and remain on your credit reports for up to seven years.
-
Fees and taxes: Debt relief companies typically charge approximately 15% to 25% of the original amount you owe to help you negotiate. They may also charge a fee for administering the savings account that you keep your settlement amount in, along with other charges. If you succeed, you may also be on the hook for taxes on the canceled debt.
-
Success isn't guaranteed: Creditors aren't obligated to work with you to negotiate a settlement. If you and your creditor can't come to an agreement, you may need to pursue other relief options, including bankruptcy. At the same time, you'll still suffer the credit consequences of withholding payments.
How to Choose the Right Option
For the most part, it's easy to tell whether debt consolidation or debt settlement is better for you because it ultimately comes down to your credit and financial situation. With that in mind, here are some scenarios where one may make more sense than the other.
Debt consolidation is right for you if:
- You have a lot of high-interest debt.
- You have good or excellent credit.
- You can afford your monthly payments.
- Your top priority is to save on interest charges.
- You're looking to simplify your monthly payments or pay off your debt more quickly.
Debt settlement is right for you if:
- You're behind on your monthly payments.
- Your credit score is in poor shape.
- You wouldn't be able to afford debt consolidation payments.
- Your only other viable option is bankruptcy.
- You're facing a lawsuit from a debt collector.
Alternative Ways to Get Out of Debt
In some instances, neither debt consolidation nor debt settlement is the right move. Depending on your situation, it could make sense to consider another way to tackle your debt. Here are some potential alternatives:
- Debt snowball method: The debt snowball method is an accelerated debt payoff strategy that orders debts from smallest to largest. You'll pay the minimum amount due on all debts and then add any extra money to your payment on the smallest balance. Once that first account is paid off, you'll roll the payment into the debt with the next smallest balance, repeating the process until all debts are eliminated.
- Debt avalanche method: With the debt avalanche method, you'll follow the same process as the snowball method. However, instead of prioritizing debts from smallest to largest balance, you'll focus on your highest-interest balances.
- Debt management plan: A debt management plan (DMP) is a repayment plan managed by a credit counseling agency. With a DMP, you may be able to negotiate a lower interest rate, lower monthly payment and other types of relief. You'll pay down your debts through the agency over three to five years.
- Bankruptcy: Bankruptcy is best considered as a last resort after you've tried everything else. The process can help you eliminate certain debts, either through liquidating assets or restructuring your repayment plan. However, it can cause considerable damage to your credit.
Check Your Credit to Evaluate Your Options
As you try to decide whether debt consolidation or debt settlement is right for you, it's a good idea to check your credit to see where you stand.
With Experian, you can get access to your Experian credit report and FICO® Score☉ for free. These resources can help you evaluate your creditworthiness and make it easier to identify areas where you can improve.
Regardless of how you choose to tackle your debt, it's important to monitor your credit regularly to understand how your actions influence your score and to address potential problems before they get out of hand.
Find out what debts you owe
Your free credit report lists all your debts, such as credit card balances and loans, helping you create a plan to tackle your debt and improve your financial health.
Review your credit
About the author
Ben Luthi
Ben Luthi has worked in financial planning, banking and auto finance, and writes about all aspects of money. His work has appeared in Time, Success, USA Today, Credit Karma, NerdWallet, Wirecutter and more.
Read more from Ben