What you need to know about debt settlement vs. debt consolidation

There are several ways to deal with mounting debt. Debt settlement and debt consolidation may both be viable options, but it’s important to assess which is the best solution to help you eliminate your current debt and improve your financial situation moving forward.

What is debt settlement?

Debt settlement allows you to negotiate with creditors to pay off delinquent, unsecured credit accounts and personal loans over a specified time (or all at once) for an amount less than what you owe. For example, a person with a credit balance of  $10,000 may be able to pay $4,000 to close and “settle” the account and have the remaining $6,000 forgiven.

When you have more debt than you can pay off and have fallen behind on payments, this is an option to consider. It’s generally best to negotiate with creditors when you’re at least 90 days past due on your payments. This is a feasible option only if you’ll have the funds to pay the negotiated amounts within the agreed-upon time, and it’s best if you can complete your settlement plan within a couple years.

What is a debt consolidation?

Debt consolidation usually means taking out a large loan from a creditor to cover the balance of all your existing loans and credit cards. The loan could be a personal loan from a bank, a peer-to-peer loan or, in some cases, a home equity loan. It can sometimes be accomplished through a balance transfer credit card.

The goal with any form of debt consolidation is to get favorable terms that include a much lower interest rate than you’re paying on the current debt. This can be a good option if you have consistent income and you take steps to change any behaviors that would lead you to again grow your debt. However, if your credit is already negatively impacted by your debt challenges, (like poor debt-to-income ratio, missed payments, etc.), you may not be approved for a new loan or credit card account or, may not get a better interest rate than you currently have.

Related article: Considering a debt consolidation loan? Here’s what to look for

Comparing the pros & cons

Debt settlement can quickly halt any debt spiral you may be trapped in and can be a quicker and lower cost option than debt consolidation. Ideally, you’ll complete your payoff plan in a couple years with debt settlement. By comparison, consolidated loan payments may last for years.

With debt settlement, your current credit accounts will be closed. If you miss your scheduled payment, your agreement with your creditor can be nullified, so it’s important to be disciplined in this process.

Once you’ve completed your settlement payments, you can apply for new credit accounts and will be able to move forward with your financial goals.

Perhaps the biggest benefit of debt settlement is that it allows you to negotiate paying less than what you owe. Just bear in mind that debt settlement has a negative impact on your credit. In order to begin negotiating with your creditors, you’ll need to be at least 90 days past due on your payments. Those missed payments are reported to the credit reporting agencies and your scores will take a major hit. It’s also likely you’ll have to deal with harassing collection calls and there is the risk of being sued by your creditors until your deals are locked in place.

Debt consolidation, however, does not run these risks and may be a better alternative if you haven’t yet fallen behind on your bill payments.

One of the biggest benefits of debt consolidation is that it can preserve your credit score. And, because you’re paying your accounts in full (and you hopefully haven’t missed any payments), you won’t face collection calls or lawsuits.

Keep in mind, though, that you may be setting yourself up to go deeper into debt, especially if it’s a spendthrift nature that got you into trouble to begin with. It’s important that you don’t incur new debt as you try to pay off your existing balances.

Related article: 5 keys to successful debt consolidation

How to assess debt settlement vs. debt consolidation

As you consider both options, take an honest look at the amount of your debt, your budget and your available funds/income. Identify short- and long-term financial goals and how your credit health will affect these.

If you’re considering debt consolidation, look at the total debt you have and the average interest rate you are paying. You can figure out how long it will take to pay off each card individually using a credit card payment calculator. Then review your budget to assess how much money you can pay toward your debt each month. You can use this debt consolidation calculator to see what loan terms will work for you. You’ll need to check with potential lenders to find out if you qualify for these terms. And be sure to consider if you have the discipline to either close other accounts or use them only in cases of emergency.

If your current debt challenges or budget prevent you from consolidating or you’d like to resolve your debt faster and are not as concerned with the impact to your credit, start by assessing if settlement will work for you. Consider:

1. Your balances. Some amounts are too small for settlement.
2. Your creditors. Each company has its own approach to dealing with delinquent accounts and their policies change periodically.
3. Your cash flow. Do you have the funds to settle all your debts within a time frame time that reduces your risk of being sued?
4. Your budget. Can you pay your settlements on time and still pay your other bills?
5. Additional funds. Are there other sources of funds, e.g., something you can sell or loans from family or friends, that you can access?

If debt settlement is the right option, you’ll work with a debt settlement company to negotiate on your behalf or you can negotiate directly with each of your creditors.

If neither option fits your situation, you may want to consider debt management or bankruptcy.

While you can negotiate with creditors directly, you’ll have to do your own research. You can calculate what you might save with a debt settlement calculator and then use a debt consolidation calculator to assess if this is a viable option for you instead. You can also use a credit card payment calculator to see how long it will take to pay off your credit card(s) if you don’t choose a settlement plan.