Debt Consolidation

Debt Settlement vs. Debt Consolidation: Understanding the Difference

“Get out of debt faster.”

“Make one low monthly payment.”

“Settle your debt for pennies on the dollar!”

If you are anything like the average American, who owes more than 26 percent of their income on consumer debt, these promises of relief can sound enticing. So much so that you may jump at any chance to ease your debt burden without exploring all the details or risks involved.

It is undoubtedly confusing to know all the available options for relieving your debt, how each one works and what is the best solution for your situation. But don’t let that confusion cause you to make a bad or uninformed decision.

In this article, we’ll take a look at two popular solutions for dealing with overwhelming debt: debt settlement and debt consolidation. We’ll dig into how they each work, how they stack up against each other and what is the best option for you.

Table Of Contents

How debt settlement works

Does debt settlement come with any risks?

Debt settlement vs. debt consolidation: which is better?

Alternative options to debt settlement

What to do if you’re committed to settling a debt

Find your best solution

How debt settlement works

Debt settlement is a type of debt relief in which you work with a service or company that attempts to negotiate and settle your debts on your behalf.

While enrolled in a debt settlement program, you typically stop paying your creditors directly and instead deposit a monthly payment (determined by the debt settlement company) into a separate bank account set up specifically to settle your debt.

Once enough money has accrued in the account, the debt settlement company uses the funds to negotiate and pay your debt, offering your creditors a lump sum that is lower than what you owe.

Since payment has been withheld for several months, or years even, some creditors are willing to settle the account for less than what is due — underpayment is better than no payment in some cases.

Debt settlement programs typically take a couple of years to complete because it takes time to accrue enough savings to start negotiations. And the fee to participate is usually a percentage of the debt enrolled in the program, the amount settled or the amount saved.

Only unsecured debt such as credit cards, medical bills, collection items, some student loans — and other debts that are not attached to an asset — are eligible for a debt settlement program.

Companies that offer these services tout several benefits including settling your debts for significantly less than you owe, getting out of debt faster and avoiding bankruptcy.

The risks of debt settlement

While the prospect of becoming debt-free faster than you would on your own, paying less than what you owe and saving money on interest is appealing, entering a debt settlement program comes with multiple risks.

Andrew Pizor, a staff attorney at National Consumer Law Center, cautions consumers about the risks involved with debt settlement and advises against it.

“You’re much more likely to end up in worse shape after trying it than when you started,” he told LendingTree.

Here is a look at some specific risks you may encounter.

Your credit takes a hit

Since most debt settlement programs require you to stop paying your debts until they can make an offer with a lump sum, your accounts will become severely past due — if they aren’t already. Your accounts may even end up in collections, or your creditors could pursue legal action before the debt is settled — both of which will damage your credit.

Also, if the debts are paid eventually, those accounts will be noted as “settled” on your credit reports, letting potential lenders or anyone else looking at your credit history know that you failed to meet the original terms of the account.

Penalties and interest will accrue

While you are in the program, your debts will continue to accrue interest, late fees and any other penalties caused by nonpayment, which can potentially increase the amount due for each of your debts.

You will still have to endure calls and other forms of contact from your creditors, and potentially face collections or further legal action.

According to Pizor, many consumers who pursue debt settlement as an alternative to bankruptcy eventually file later down the road. “A good number of people who went into debt settlement specifically to avoid bankruptcy ended up having to file bankruptcy anyway to get rid of all the lawsuits that come up.”

After accruing late payments and penalties on your accounts and receiving derogatory marks on your credit report, you could potentially end up in a worse situation than you were before entering debt settlement.

High fees

Working with a debt settlement company can come with high fees. Depending on the service you use, you may be charged a portion, typically 15 percent, of the total debt settled or the amount saved. Some companies may charge more. The Federal Trade Commission (FTC) warns against working with any company that charges fees upfront before settling a debt. You definitely don’t want to pay for a service before you reap the benefits.

Taking the fees into consideration, the savings you realize from settling your debt is diminished. Additionally, you may be charged fees to maintain the separate bank account dedicated to debt payments.

Forgiven debt may be taxable

If the debt settlement program is successful, the amount of debt that is forgiven may be considered taxable income, leaving you with a tax bill the next time you file. This is another factor that cuts into any savings from settling your debts.

High potential for scams

While some services legitimately attempt to settle debts, the industry is fraught with disreputable practices, from promising specific results to charging fees upfront. Consumers who are in financial distress and are looking for relief can be susceptible to false promises and “too good to be true” scenarios.

For this reason, Pizor says the risks of working with a debt settlement company far outweigh the potential relief. “They range from scams to deceptive to well-meaning but incompetent. Your chances of getting a debt settlement service that does what they say they’re going to do are so low,” he told LendingTree.

Potential of paying more

Even if the debt is settled, once you add in the fees, additional charges, and tax implications, you could potentially be paying more than what you owed in the first place or what you could have negotiated yourself.

There is no guarantee of success

One of the most significant risks of pursuing debt settlement is that it may not work. While debt settlement companies can claim results they have received in the past, they cannot guarantee success or specific results in your case.

Pizor warns that some creditors may be unwilling to talk to a third party regarding your debt.

“A lot of people don’t realize that creditors are not required to listen to any debt settlement company,” he said, adding that some of the large creditors refuse to talk to third parties at all. “They have absolutely no authority to do anything you can’t do on your own.”

High dropout rate

Any potential success a debt settlement company can bring requires completion of the program. Unfortunately, many consumers drop out of debt settlement programs, having made payments into the dedicated account for several months without seeing a single debt negotiated. When this happens, the accounts accrue late fees and penalties in vain.

Debt settlement vs. debt consolidation: which is better?

Debt consolidation is another debt relief option you may have heard of. While there are multiple ways to consolidate debt, the main idea is to take the numerous debts you are paying at various interest rates to several different creditors and replace it with one debt and one payment at a single interest rate (ideally a low one).

There are multiple ways to consolidate your debt including:


Debt consolidation doesn’t reduce the amount of debt you have — it merely moves the debt. It can potentially lower your monthly payment and reduce the amount of interest you pay on some of your debts, provided the new loan is at a lower rate than all the individual rates. But sometimes it can also raise the interest on some of your debts.

Choosing debt consolidation can streamline your finances by taking the confusion out of juggling multiple creditors and payments, various due dates and different terms. However, it can also provide a false sense of relief that you paid off debt. It can also extend the total amount of time you are paying down the debt.

“Don’t just look at the total monthly payment,” Pizor warned. “That’s why a lot of people want to consolidate — to have a lower monthly payment. But you need to think about the long term. Are you going to be paying more over time in interest?”

There are risks involved with debt consolidation, such as taking unsecured debt like credit card debt or medical bills and attaching it to an asset if you consolidated with a HELOC, home equity loan or cash-out refinance.

Additionally, you could set yourself up to go further into debt by freeing up credit without addressing the issue that led to debt.

Here is a glance at some of the differences between debt settlement and debt consolidation.

Debt Settlement vs. Debt Consolidation
Factors to consider Debt settlement Debt consolidation
Effect on credit Late payments and potential collection accounts can stay on your report for seven years. Also, negotiated debts will be labeled as “settled,” a derogatory mark. You may experience an initial dip in your credit score when opening a new credit card or taking out a new loan with an institution, but you should see a gradual increase over time.
Timeframe on debt repayment Varies Varies
How much debt gets repaid? Some companies claim they can settle a debt for as low as 30 to 50 percent of what is owed (before fees) but companies cannot guarantee certain outcomes. If the new loan or credit card balance is large enough, all the debt can be consolidated.
Debt & credit requirements Usually, no credit score is required. Personal loan companies work with people with a variety of credit scores but the best terms are reserved for those with excellent credit. To get approved, lenders will also look at your income.
Can I do this on my own? Yes. You can attempt to negotiate and settle debts directly with your creditors. Yes, you can shop and compare debt consolidation loans.
Fees Fees can be 15 percent of the debt paid or amount saved, or higher.


There may be a balance transfer fee of 3 to 5 percent or, with personal loans, a loan origination fee of 0 to 8 percent.
Tax implications You may be responsible for taxes on the forgiven portion of the debt. Typically no, unless you use a 401(k) to consolidate and it is not paid back as agreed.
Can I continue to use accounts after paying them off? No. The accounts will be closed. Yes

Alternatives to debt settlement

Before heading down the path to debt settlement, be sure you thoroughly explore all your options. Because there are so many risks involved, it is in your best interest to know the alternatives.

Debt management plan

A debt management plan is a type of consolidation in which you usually work with a credit counselor. The goal is to manage your debt and get you back into good graces with your creditors.

Your actual debt is not consolidated, but your payments are; you make a single payment to a separate account managed by your counselor or the debt management company, which in turn pays your multiple creditors. The amount owed is not reduced, although some creditors may make concessions on fees and interest rates.

There is a fee involved in participating in a debt management plan. This could be a solution if your financial situation is so overwhelming that you avoid taking action.

Chapter 7 bankruptcy

Of course, bankruptcy is a last resort but if debt settlement may lead you there anyway, preemptively filing for Chapter 7 bankruptcy, in which your assets are liquidated and most debts are forgiven, might be a better solution for you.

While bankruptcy can also wreak havoc on your credit, it can have some benefits over debt consolidation or debt settlement, including being more of a sure thing.

What to do if you’re committed to settling a debt

If you believe entering a debt settlement program is the best debt relief option for you, proceed with caution. Keep the following tips in mind.

  • Avoid working with any company that guarantees specific results ahead of time or requires payment upfront.
  • Do your homework and research the company via the Better Business Bureau, your state attorney general or local consumer protection agency.
  • Read the fine print and ask questions before agreeing to work with anyone. According to the FTC, debt settlement companies must disclose the following:
      • Price and terms: The company must explain its fees and any conditions on its services.
      • Results: The company must tell you how long it will take to get results — how many months or years before it makes an offer to each creditor for a settlement.
      • Offers: The company must tell you how much money or the percentage of each outstanding debt you must save before it will make an offer to each creditor on your behalf.
      • Nonpayment: If the company asks you to stop making payments to your creditors — or if the program relies on you to not make payments — it must tell you about the possible negative consequences of your action.

  • Make sure the fees are based on the amount of debt settled and not the amount of debt entered into the program.
  • Find out what happens in the event the company is successful in settling your debt.
  • Compare the costs of multiple programs.
  • Get the terms of your agreement in writing.
  • Find out ahead of time if your creditors will work with a third party.

Find your best solution

Before you jump into debt settlement, attempt to contact your creditors directly. “Your creditors are actually more likely to talk to you than they are to any debt settlement company,” Pizor said.

If you do proceed with a debt settlement program, again, know the details. Find out exactly what the program entails, what it will cost and how long it will take. Read the fine print, and be sure it is the best solution for you.

And before pursuing any debt relief solution, talk to a nonprofit credit counselor who can provide you with an objective look at your situation and the best course of action for you. When considering all your options, make sure you think about not only the immediate short-term benefits but also the long-term consequences.


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