Debt Consolidation

Debt Consolidation vs. Debt Settlement: Weigh Your Options

If you’re like the average American, you’ve looked into ways to eliminate your debt – once and for all. The good news is that there are a number of ways to do it. Below, we’ll explore two popular debt payoff strategies: debt consolidation and debt settlement.

Debt consolidation is a way to combine one or more debts and pay them off with a single monthly payment, ideally with more favorable terms. A debt settlement, on the other hand, is a way to renegotiate the terms of what you owe so a creditor is willing to accept less than what is owed. Each approach has its own benefits – and distinct drawbacks. With both strategies, you’ll need to do due diligence to make sure you’re not feeling the financial effects long after your debt is gone.

How debt consolidation works

Debt consolidation in practice involves taking out a new loan or line of credit to help pay off existing debt. It doesn’t actually reduce the amount of debt you owe. But it can lower your monthly payment and save money on interest if your new loan or line of credit comes with a lower interest rate than the individual rates on your debts.

Here are common ways to consolidate debt:

  • Home equity loan or home equity line of credit (HELOC): With a home equity loan, you can cash in on the equity in your home to pay off other debts, often at a lower (and fixed) interest rate than you’d get with credit cards or a personal loan. With a HELOC, you get access to a line of credit that can also be used to pay off debt, usually at a variable interest rate that might make monthly payments harder to budget.
  • Cash-out refinance on your mortgage: This refinancing option lets you take out a new loan on your home that will both pay off the old loan with better terms – and provide cash for other uses, like paying off debt. It typically carries a lower interest rate than a home equity loan, but fees can add up.
  • Debt consolidation with a personal loan: You won’t need collateral like a house to secure a personal loan to pay off debt, but for your best interest rates you will need strong credit, a reliable income and a low debt-to-income (DTI) ratio.
  • Balance transfer credit card: A balance transfer lets you move existing credit card debt onto a new credit card that preferably has a better interest rate. To qualify, you’ll need good to excellent credit, and a history of paying bills on time.
  • 401(k) loan: You won’t need a credit check to take out a low-interest loan against the money you have in your 401(k) retirement account, but expect withdrawal and loan term limits.

Debt consolidation can streamline your finances by taking the confusion out of juggling multiple creditors and payments, various due dates and different terms. Plus, you can potentially shorten your repayment period and improve your credit score while repaying debt.

It does come with risks. For example, if you were to take out a home equity loan to help pay off credit card debt – and use your house to secure the loan – you could lose your home if you were unable to make payments. Or, if you were to take out a personal loan and couldn’t repay it, you could see your credit score drop, on top of having to pay fees and penalties.

How debt settlement works

Debt settlement is a type of debt relief in which you either negotiate on your own to settle debt with your creditors – or work with a for-profit company that will attempt to do the same on your behalf. The goal is to get creditors to agree to settle accounts for less than what is due, on the grounds that some payment is better than no payment at all.

Trying to settle debt on your own can be time-consuming, but it lets you bypass working with a debt settlement company, an option we don’t recommend. However, there’s no guarantee a creditor will settle.

Be wary of debt settlement programs. When you enroll in a debt settlement program, you typically stop paying your creditors and instead deposit a monthly payment into a separate bank account set up by the settlement company. Once enough money has accrued in the account, the company uses the funds to negotiate with creditors for a lump sum that is lower than what you owe.On average, debt settlement programs take three or more years to complete. These programs can come with hefty fees (more on that below).

The risks of debt settlement

  • Your credit takes a hit. Because most debt settlement programs require you to stop making payments, your accounts could become severely past due and end up in collections.
  • Penalties, late fees and interest on your debts will continue to accrue. This can potentially increase the amount due for each debt.
  • Fees are typically high. Debt settlement fees are typically 18% to 25% of the total debt enrolled in the program, but companies can also charge you a portion of that fee for debt that’s been settled.
  • Forgiven debt may be taxable. If the debt settlement is successful, the amount of debt that is forgiven could be considered taxable income.
  • There’s a high potential for scams. While some companies legitimately try to settle debts, the industry is fraught with predatory practices, from promising specific results to charging fees upfront.
  • You might have to pay more in the long run, even if your debt is settled. Once you add in additional charges, fees and tax implications, you could end up paying more than what you owed in the first place.
  • There’s no guarantee it will work. Debt settlement companies are not required to guarantee success or specific results. If you drop out, your credit will see serious damage and debt collectors may still keep contacting you.
  • The dropout rate is high. If you drop out, you are entitled to withdraw your payments (but not any paid fees) without penalty, according to the Federal Trade Commission (FTC).

Debt consolidation vs. debt settlement: Which is better?

This will depend on your situation. For some consumers, debt consolidation will be a better choice. It offers a streamlined approach to getting out of debt once and for all. However, it also requires good credit to receive your best loan terms, and the ability to keep up with payments. If you have an unmanageable amount of debt or know you’ll struggle to pay it off on your own, debt settlement might be worth considering – especially if you’re willing to try to negotiate with creditors on your own.

If you opt to work with a debt settlement company instead, you’ll see a few additional factors to consider in this list of debt relief pros and cons:

Comparing debt consolidation and debt settlement
Factors to consider Debt consolidation Debt settlement
Fees With balance transfer credit cards, fees are 3%-5% of the transfer amount; personal loans can have origination fees between 1%-6%. Fees are often 18%-25% of the enrolled debt, plus enrollment and account maintenance fees.
Effect on credit Expect an initial dip in your credit score when opening a new credit card or taking out a new loan. Even if you had no late payments, settled accounts stay on your credit report for seven years.
Tax implications Typically none, unless you use a 401(k) loan and loan is not paid back. You may need to pay taxes on the forgiven portion of the debt.
How much debt gets repaid? You could save on interest payments, but you’ll still have to repay the entire amount owed. Expect to pay back 50% to 80% of the debt you owe.
Debt and credit requirements For personal loans and balance transfer cards, expect your best terms if you have excellent credit. For personal loans, lenders will also look at income. Typically, no credit score is required.
Can I continue to use accounts after paying them off? Yes. No, the accounts will be closed.

When you should choose debt consolidation…

If you anticipate being able to pay off your debt in a reasonable amount of time, consider debt consolidation. It’s also the right path if you care about preserving your credit score.

When you should choose debt settlement…

Consider trying to settle your debt if you have an unmanageable amount of debt, are willing to risk your credit score and bankruptcy isn’t an option. If you decide to work with a settlement  company, look for a reputable name and check its standing with local consumer protection agencies and your state attorney general’s office.

How to consolidate debt

  • Get your finances in order. Determine exactly how much debt you have and the repayment terms and interest rates on each amount; also check your credit score. To find ways to consolidate credit card debt, consider these options.
  • Decide which method works best for your financial situation. If you have significant equity in your home, consolidating debt with a home equity loan or HELOC might offer a better interest rate than a balance transfer credit card. Or, if you have a small amount of debt you can pay off quickly, a balance transfer card may make more sense. If you have excellent credit, a personal loan might be a viable option for a longer repayment term.
  • Shop around. With a balance transfer card, for example, you’ll need to compare interest rates as well as transfer fees. If a loan seems to make more sense, find lenders and see if you prequalify. Prequalification doesn’t hurt your credit but can give you an idea of the terms you’d qualify for.
  • Compare offers and choose a creditor. Check fee structures, compare rates and terms to find a creditor that works for you.
  • Make sure you have key documents, like proof of income, employment and debts. A formal application will require a hard credit check, which will result in a small ding to your credit.
  • Wait for approval. If approved, you can use your new line of credit or loan to pay off your existing debt. If you’re denied, check in with the creditor to learn why you were denied so you can make changes to improve your credit for future applications.

How to settle debt

  • Do your homework. Look into settling debts with creditors on your own; it’s almost certainly less expensive than working with a debt settlement company. If you do go with a company, avoid working with any that guarantee specific results ahead of time or require payment upfront.
  • Read the fine print. Debt settlement companies must disclose certain information, including the price and terms; how long it takes to get results; and how much money you must save before an offer is made, according to the FTC.
  • Ask questions. Make sure the fees are based on the amount of debt settled and not the amount of debt entered into the program.
  • Get the terms of your agreement in writing. Fees, for example, may vary depending on how much debt you’ve enrolled and how much has been settled.

Alternatives to debt settlement and debt consolidation

Debt management plan

A debt management plan involves working with a nonprofit credit counselor to pay off your debt, as well as learn about healthy financial habits.

Here’s how it works: You make a single monthly payment to a designated credit counselor, who then uses the money to pay your various creditors. The total amount you owe won’t be reduced, but your credit counselor will likely be able to negotiate down interest rates and fees.

Fees are typically around $25 to $50 per month. If you also have to pay an enrollment fee, it’s usually less than $75. Fees might be waived depending on your  financial situation.

Debt snowball or avalanche

If you’d like to pay off your debt without the help of a third party, consider two popular debt payoff strategies: the debt snowball and the debt avalanche.

The debt snowball method involves organizing your debts and paying them off from smallest to largest balance. The debt avalanche, on the other hand, involves paying off your debts from highest to lowest interest rate.

The debt avalanche is the more financially sound path as you save money by tackling your highest interest rate debts first. However, your highest interest rate debt might also be your largest balance. For this reason, many people prefer the debt snowball. The little “wins” that accompany paying off debts quickly can help you stay on track.

Bankruptcy

Bankruptcy should always be a last resort. But if it’s likely that debt settlement will lead you down that path anyway, preemptively filing for bankruptcy could save you time, money and stress.

With Chapter 7 bankruptcy, your assets are liquidated and most of your debts are forgiven. With Chapter 13 bankruptcy, you’re able to keep some of your assets (like your home) but you’re enrolled in a strict repayment plan that typically takes three to five years to complete.

While bankruptcy will wreak havoc on your credit for years to come, it’s often the only option for consumers with significant debt who are looking for a clean slate. Still, consider consulting a bankruptcy attorney or nonprofit credit counselor for advice before filing.

 

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