Debt Consolidation or Debt Settlement?

The path to financial wellness often involves wading through the waters of either debt consolidation or debt settlement. One of these will always be better for you than the other. This article will help you make the best decision for your particular situation.

Debt consolidation vs. debt settlement: What you need to know

Both debt consolidation and debt settlement are debt relief strategies. You should exercise due diligence by carefully considering both strategies. But that’s where the similarity ends.

Debt consolidation reduces the number of creditors by combining debts into a single monthly payment. Debt settlement, on the other hand, reduces the total debt you owe after renegotiating the financial terms so that the debt is settled for a lower amount that is due.

Read on to better understand the various facets of both these strategies so that you can decide which one will work best for you.

Debt settlement

People typically choose debt settlement when it is too challenging to repay their debt in full. This strategy involves negotiating with the lender to reduce the total value of debt owed. Debt settlement offers two options: payment in a lump sum or via installments.

This debt relief method — also called debt forgiveness — is a way for creditors to forgive debtors. But there is no guarantee of reaching an agreement.

Types

There are two types of debt settlement:

1. DIY debt settlements: Do-it-yourself debt settlement can be done for free. You negotiate with the lender yourself. This requires good negotiation skills or a detailed primer on the subject. This method involves a considerable investment in time rather than money.
2. Working with a for-profit debt settlement firm: In this case, a for-profit debt settlement firm negotiates on your behalf. Because not all debt settlement firms are reputable, you should choose a firm carefully based on personal recommendations, online reviews, accreditations and a lot of good sense. Debt settlement firms in this line of work typically charge a fee of 15% to 25% of the enrolled debt.

Risks

Debt settlement comes with several inherent risks due to the nature of the deal — asking a creditor to lower the payable amount, which any person or organization would dislike. Who wants to be paid less than they are owed?

• The first strike could be to your credit score. If your debt settlement program asks you to stop paying your creditor, which they usually do, the first casualty will be your credit score.

• You may pay more due to late fees, penalties and accumulated interest.

• The fees you pay for debt settlement — usually between 15% and 25% — will increase your total payable amount.

• If your forgiven debt exceeds $600, you must pay taxes on it.

• Fraudulent organizations are rife in this field, so you may fall prey to scams.

• Debt settlement comes with no guarantee, so your lender may not accept the settlement.

• Dropouts are common in debt settlement. If you drop out, your credit score will fall, and you may have to face debt collectors again and again.

• You could also be sued and thus face stress and embarrassment.

How it impacts your credit score

Debt settlement can impact your credit score negatively. If you settle a debt, it stays on your credit report as “settled” for seven years from the delinquency date. This makes it difficult and costly to secure further credit from credit unions.

When working with a debt settlement company, you may be asked to stop making credit payments. One reason for this is creditors ask for full payment unless you default, so defaulting is a tactic to get your creditor to accept a lower payment.

Falling behind in payments brings down your credit score because payment history is an important score determinant. Credit scores can recover with time, but it is usually quite a long time.

How much of a negative impact debt settlement will have on your credit score depends on your creditors’ reporting practices, the amount of debt that’s being settled, the amount of debt that’s being reduced, the current state of your other debts — whether they are in good standing or not — and your pre-settlement credit score. The higher your credit score before debt settlement, the more it will drop.

Credit scores reward timely payments made according to the credit agreement, and this falls in neither of those categories. In fact, debt settlements are sometimes as damaging to credit scores as bankruptcies.

Debt consolidation

Debt consolidation reorganizes debt by consolidating several individual debts into a single loan. It allows you to bunch the debt owed to several creditors into a single monthly payment.

Take the example of Jason. He owes $5,000 each to three creditors. He consolidates these into a single payment of $15,000. This allows him to pay off all three debts in a single monthly payment. And did we mention Jason has a lower interest rate on the consolidated debt? This means quicker loan repayment and lower total cost.

Types

The types of debt consolidation are:

• A personal debt consolidation loan: If you have a strong credit score, regular income and a low debt-to-income (DTI) ratio, you should qualify to use a personal loan to consolidate your debt repayment. No collateral — like a house, car or another asset — is needed.

• Home equity line of credit (HELOC): Your home’s cashable value (equity) can be used to pay off credit card debts or personal loans at lower interest rates.

• Balance transfer credit card: If you have good to excellent credit and a record of paying your credit card bills on time, you can bunch existing credit payments into a single balance transfer credit card.

• Mortgage refinancing: This option lets you take out a new home loan that can pay off your old home loan and can also give you extra cash on hand.

• A 401(K) loan: If you have money in a 401(k) account, you qualify for a low-interest credit consolidation loan with possible withdrawal and loan term limits.

Risks

The kind of debt consolidation you can secure will depend on several factors, including your taxable income. And the risks of debt consolidation include the following:

• You may not get a lower interest rate than your various debts’ combined annual percentage rates (APRs).

• Credit scores often take a short-term hit from debt consolidation but can get better in the long run if the process goes smoothly.

• If you have used collateral for debt consolidation, you could lose it.

• Debt consolidation loan fees are another added expense.

• Using credit cards for debt consolidation will result in a higher credit utilization ratio, which will hurt your credit score.

How it impacts your credit score

Debt consolidation can both raise and lower your credit score.

Debt consolidation can raise your credit score when:

• Your balance transfer credit card has a higher credit limit. This means you may use a lower percentage of your credit limit. Due to lower credit utilization, your credit score benefits.

• You make on-time payments, which results in a positive payment history, raising your credit score.

Debt consolidation can lower your credit score:

• Opening a new account for debt consolidation will lower the average age of all accounts.

• With a balance transfer credit card, the credit card sometimes comes with a lower credit limit. This may result in you using a higher percentage of credit limit, thus lowering your credit score.

• When you apply for credit, the creditor requests to see your credit file. This leads to a temporary lowering of your credit score.

Debt settlement program pros and cons

The pros

• Working with debt settlement programs accredited by the Better Business Bureau (BBB) and American Fair Credit Council (AFCC) could lead to potential gains.

• Some creditors accept lump sum payments of only 50% of the total amount due. This means you save money even after paying the debt settlement agency fees, late fees and interest.

• A debt settlement program is the fastest way to pay off debt for some people.

The cons

• A forgiven debt of over $600 is taxable.

• Creditors can take legal action, such as garnishing wages and freezing bank accounts.

• The industry is rife with scams.

• Creditors can refuse to accept the debt settlement for an amount lower than the original debt.

• Settlement and any late fees add to the total payable amount.

• Debt settlement often damages an individual’s credit score as much as bankruptcy does.

• Debtors often drop out of debt settlement programs because they cannot sustain regular payments.

Debt consolidation program pros and cons

The pros

• Because debt consolidation means fewer accounts, it simplifies account management.

• Cash savings are often a byproduct of the best debt consolidation loans.

• You may find repaying easier with a debt consolidation program that offers smaller monthly cash payments, even though the payment terms stretch for longer.

The cons

• Although consolidation can make your financial burden seem more manageable, that burden does not disappear.

• People with poor credit can’t take full advantage of debt consolidation programs. You can take several steps to improve your credit score, though.

• Fees — like application and origination fees — can make debt consolidation expensive.

How to determine which is right for you

You can use the following as a guide to determine whether you should choose debt consolidation or debt settlement for your financial needs.

Debt settlement is a good fit for you if:

• You don’t have perfect credit.
• You don’t qualify for a low-interest consolidation loan.
• You can’t declare bankruptcy.
• You don’t mind a lower credit score.

Debt consolidation is a good fit for you if:

• You want a simplified debt payment plan and the resulting peace of mind.
• You qualify for a lower interest rate.
• You are willing to organize a debt repayment plan.

Choosing between debt consolidation or debt settlement is easy when you have the proper perspective. Use the following table to determine which is right for you:

Factors	Debt settlement	Debt consolidation
1. Amount of repaid debt:
2. Effect it has on credit score:
3. Taxes:
4. Fees:
5. Credit requirements:
6. Ability to use the accounts after paying off debt:

Give debt settlement and debt consolidation a rating of one to five stars for each factor, with one being the lowest and five the highest. Rate both options on each of the six factors based on how each will affect you personally. Then total the debt consolidation and debt settlement columns. The option with the higher score likely means it’s the better option for you.

What are the alternatives to debt consolidation?

Some possible alternatives to debt consolidation are:

• Choosing debt settlement
• Enrolling in free credit coaching
• Speaking to your creditors
• Living on a strict budget

Two popular methods for paying off debt are the debt snowball and the debt avalanche. The debt snowball involves paying off debts systematically from the smallest to the largest — regardless of each debt’s interest rate. You make more payments on the smallest debt and minimum payments on the larger ones. As soon as the smallest debt is paid off, the freed amount is used for the next largest debt. This pattern continues until all debts have been paid off.

The debt avalanche pays off the debt with the highest interest rate first — regardless of the actual debt amount. Using the debt avalanche method, you make minimum payments on your other debts with lower interest rates. Like the snowball method, you follow the pattern of maximizing payment to one loan at a time, beginning the process again as each debt is paid off.

Find the right debt management plan for your financial situation

When selecting the best debt management plan for you, choosing the right credit counseling agency is essential. The agency should be a member of the Financial Counseling Association of America or the National Foundation for Credit Counseling. Check their ratings with the BBB and on third-party review sites.

You should also check the access to the program — is it by phone, online or in person? — and determine what works best for you. And last but not least, be sure the plan’s cost fits your budget.