At a Glance
Many roads can lead to the same destination. Paying off debt is one of those scenarios. There are multiple ways to do it, some good, some not-so-good. We’ll examine two of the most popular: debt consolidation and debt settlement. We’ll outline the pros and cons of both and present a debt consolidation vs. debt settlement comparison.
What is Debt Consolidation and How Does it Work?
Debt consolidation is the process of combining all your debt into one lump sum, then taking out a loan to pay it off. The idea behind this is to lower interest rates if your credit score allows. Most Americans carry high-interest credit card debts. Personal loans offer lower interest rates and allow you to stretch out payments over a longer period. Those payments are fixed, so they’re easier to budget.
Paying off the outstanding credit card balances is only one step in what should be a two-step process for debt consolidation. To achieve complete freedom from debt, it’s necessary to stop using your credit cards while you’re paying off the consolidation loan. Failure to do this could result in increasing your total debt instead of discharging it.
Pros of Debt Consolidation
- Eliminates high-interest credit card debt
- Lowers monthly debt payments
- Makes it easier to budget
Cons of Debt Consolidation
- Additional loan on your credit report
- Leaves credit card accounts open for more spending
What is Debt Settlement and How Does it Work?
Debt settlement is different from debt consolidation because the objective is to pay off less than the full balance on all debt accounts. To do this, consumers need to withhold monthly payments until the credit card companies are willing to negotiate. It’s risky because credit scores are affected by missed payments, but it can save the consumer money.
Payment history accounts for 35% of an overall FICO score, so missing payments can have a significant impact on your ability to get approved for new credit in the future. It’s also important to understand that the remainder of your debt after the settlement amount is accepted doesn’t simply “go away.” You may be required to pay taxes on it.
Pros of Debt Settlement
- Debts are paid off for less than the full balance owed
- More cash on hand while payments are being withheld
Cons of Debt Settlement
- Credit scores will decrease with each missed payment
- Remainder after settlement amount may be taxable
What is Better? Debt Consolidation or Debt Settlement?
Is debt consolidation better than debt settlement? In the short run, debt settlement will save you a few dollars, but the impact on your credit score from those missed payments could last years. You may also be responsible for paying taxes on the remainder of your debt after the settlement has been accepted. Debt settlement is not a great option.
With debt consolidation, the main danger is that your credit cards will have zero balances and maximum purchase power after you pay them off. A common misstep in this scenario is running up those credit card bills again while you’re still making loan payments. Otherwise, debt consolidation is a far better option than debt settlement.
Frequently Asked Questions
Is Consolidation the Same as Settlement?
No. The biggest difference between debt consolidation and debt settlement is that debt consolidation pays off the entire balance of outstanding debts, while debt settlement only pays a percentage. The two payoff methods are also listed differently on your credit reports.
Is Debt Relief and Debt Settlement the Same Thing?
No. Debt relief is asking credit card companies and lenders to lower monthly payments or reduce balances due to a hardship. This is often done after a natural disaster (or pandemic), or when debtors have financial problems or economic instability. This is also very different from debt consolidation.