Debt consolidation vs. debt settlement

What does debt consolidation mean?

Debt consolidation combines multiple debts into one debt with a single interest rate. This way, you don’t have to worry about paying multiple lenders with varying rates, due dates and minimum payments.

The main advantage of debt consolidation is simplicity: Tracking only one balance means you’re less likely to miss payments and incur fees. Debt consolidation loans also often have lower monthly payments and/or annual percentage rates (APRs) than, say, credit cards.

“You have the opportunity to save money, which could translate to hundreds, if not thousands, of dollars over the life of your loan should you be able to secure a lower APR,” said Christopher Stroup, a certified financial planner with Abacus Wealth Partners.

Still, debt consolidation isn’t always a perfect solution. If you choose a long debt consolidation loan term with a small monthly payment, you might end up paying a lot of money in interest over time.

Also, be aware that the debt consolidation industry is rife with hidden fees and “teaser rates” that ultimately expire. Keep an eye out for any predatory lending practices.

» MORE: How to manage your money

How debt consolidation works

Debt consolidation works by rolling multiple debts into one. The chief benefits of debt consolidation are simplicity, stress relief and possibly a lower overall interest rate. But different debt consolidation products have different benefits and drawbacks.

Debt settlement meaning

Debt settlement is the process of asking a lender if you can settle for less than you owe. Most lenders will only consider debt settlement if the account is significantly overdue and you have the cash on hand to settle it.

For example, if you owe your credit card company $10,000 and you recently lost your job, you might be able to negotiate a $5,000 settlement (as long as you have proof that you have $5,000 in cash to give).

The reason a lender would even consider settling for less than what it’s legally owed is quite simple: Something is better than nothing. In the case above, your credit card company gave you an unsecured line of credit, meaning there’s no collateral it can legally repossess (e.g., a car or home) to recoup its losses.

In this case, the card issuer’s options boil down to sending your account to collections and possibly receiving nothing or taking your $5,000 cash offer now. It can be something of a win-win situation for both a borrower and their lender.

“The pros of debt settlement include speeding up the repayment process, reducing the total amount owed and simplifying your repayment plan,” said Stroup. “By negotiating with creditors to settle for less than the full amount, you can quickly lower debt and save money.”

But slashing your bill doesn’t come without risk or consequence. Here are some of the biggest drawbacks to debt settlement:

• It will almost certainly damage your credit.
• Third-party debt settlement companies charge high fees (up to 25% of your total debt) to negotiate with your creditors.
• You’ll owe taxes on the forgiven portion of your debt.
• The process can take years of negotiating, and there’s no guarantee that a creditor will accept a settlement offer.

So while debt settlement can drastically reduce your debt load, its unpleasant side effects are why it’s often considered a last resort after tactics like debt consolidation, credit counseling and other options have been exhausted.

» MORE: Credit counseling vs. debt settlement

How debt settlement works

Debt settlement involves negotiating with your lender once your accounts are significantly overdue. Some lenders may settle for as little as 50% of your current balance. But you may need to pay cash, and the long-term impact on your credit can be severe.

There are two main ways you can approach a debt settlement: You can try bargaining with your lender yourself, or you can outsource the negotiation to a third-party settlement company.

Difference between debt consolidation and debt settlement

While they sound similar at first glance, debt consolidation and debt settlement are two very different ways to reduce your debt, and each is suited to different circumstances.

Debt consolidation might be a better fit if you’re just trying to organize your debts in one place and potentially save some money on interest. Debt settlement is often considered a last resort before bankruptcy. In either case, credit counseling may help you choose the best path forward.

Other debt management options

Debt consolidation and debt settlement are just two of many debt-reduction strategies you can implement to effectively manage your debt load.

• Credit counseling involves working with a counselor through a nonprofit that can help you manage your finances, set up a debt management plan and rebuild your credit. Initial sessions are often free, and the National Foundation for Credit Counseling (NFCC) reports that 73% of consumers it works with are able to pay their debts more consistently.
• The debt snowball is a simple debt repayment strategy that involves paying off your debts in order of outstanding balance, starting with the smallest. The idea is to clear your small debts quickly, which may give you momentum and motivation to keep going.
• The debt avalanche is similar to the debt snowball method but involves paying off your debts in order of highest to lowest interest rate. This method may be more efficient and result in paying less interest, but since it can leave your individual loans open for longer, some find it demotivating.

Keep in mind that these strategies aren’t necessarily mutually exclusive. You may decide to set up a debt snowball while simultaneously negotiating for a debt settlement on your most delinquent loan.

» MORE: How to get out of debt

Bottom line

Debt consolidation involves rolling your debts into a single balance to simplify your finances, avoid missed payments and possibly reduce your interest rate. Debt settlement involves negotiating down an outstanding balance with its creditor.

Due to its mixed success rate and severe credit impact, debt settlement is often considered a last resort before declaring bankruptcy. If you’re simply looking to better manage your existing debts, credit counseling and debt consolidation may be the right next steps.