Which is better? Debt consolidation vs. debt settlement

You can turn to debt settlement or consolidation to reduce the amount you owe creditors. Both debt consolidation and settlement have pros and cons and provide different paths for paying down your debt. Here's a closer look at these debt-reduction strategies.

How debt settlement works

With debt settlement, you negotiate with your creditors to settle a large portion of your debt, offering to pay less than what you owe. The forgiven amount will vary depending on what you can negotiate with your lender.

For example, you currently have a $10,000 balance on one of your credit cards. You negotiate with your lender, and it agrees to let you pay $7,000. In this case, your creditor forgives the remaining $3,000 you owe.

You will have to negotiate separately with each of your creditors for each debt you want to settle.

How debt consolidation works

Debt consolidation is a payoff strategy where you take out a new loan and pay off the balance of existing debts. You have one loan to repay, ideally with a lower monthly payment.

Remember that with debt consolidation, your debt might get reduced, but it isn't forgiven. You might have a lower interest rate on your new loan, but your debt remains, and you must pay it off over time with regular monthly payments.

Advantages and disadvantages of debt settlement

Now that we understand debt settlement, let's review the pros and cons.

Pros

A portion of your debt might be forgiven. The obvious benefit of debt settlement is that your creditors might forgive a portion of your debt. If you owe a lender $14,000 and agree to pay $8,000 to make that entire debt disappear, you saved yourself $6,000.

You can do it on your own. You don't have to work with an outside company to settle your debt. You can contact your credit card providers or lenders directly and make offers to them.

Cons

There can be drawbacks to debt settlement, especially if you work with debt settlement companies instead of approaching lenders and banks on your own. The Consumer Financial Protection Bureau says dealing with debt settlement companies can be risky.

Settlement companies can be expensive. Debt settlement companies charge varying fees, but you can expect to pay 15% – 20% of your total debt. The Federal Trade Commission warns that you should only work with debt settlement companies that list their fees in writing and never work with one that charges fees before it settles the debt for you.

You could owe more in taxes. You may owe a substantial amount in outstanding taxes on your settled debts. The Internal Revenue Service regards debt that's been forgiven as a form of income. You will be expected to include forgiveness information on your tax return and to pay income taxes on the forgiven amount.

Debt settlement can plummet your credit score. Debt settlement companies often ask that you not make any payments to your creditors while they're negotiating on your behalf, but this can cause significant damage to your credit score. When you make payments on certain monthly debts – such as your mortgage, auto loans, or credit cards – more than 30 days past your due dates, these missed payments are reported to credit bureaus.

Your creditors don't have to accept your offer. A debt settlement company might make what it considers a fair offer to your credit card provider or lender. However, there's no guarantee that your lender will agree to work with the debt settlement company or accept anything less than the full amount you owe them.

Advantages and disadvantages of debt consolidation

A debt consolidation loan might result in a more minor hit to your credit score and come with lower upfront costs. However, paying off debt with a debt consolidation loan can be more time-consuming.

Pros

• The process is easier. With debt consolidation, you can combine several monthly payments into a single payment. This can simplify your debt repayment process.
• You might end up with a lower interest rate on your debt. The goal is to get a debt consolidation loan with an interest rate lower than the average rate charged on the debt you already have. If you can do this, you'll save money as you repay your loan over time.
• On-time payments each month can help your credit score. Every time you make a payment on your debt consolidation loan, it will be reported to credit bureaus. Make these payments on time each month, and your credit score will improve steadily.
• It'll stop any annoying debt collection calls. Once you're paying off your debt consolidation loan each month, those calls from debt collection agencies will most likely stop. This perk can further reduce the stress of your debt repayment journey.

Cons

• It can take a while to pay the debt off. Unlike debt settlement, it can take a long time to repay your debt using consolidation. That's because creditors usually don't forgive any of your debt in the process. You'll have to steadily make monthly payments – often over several years – to eliminate this debt.
• It requires discipline. Debt consolidation won't work if you stop making payments on your new loan. It also won't work if you continue running up new credit card charges. Consider hiring a credit counseling agency or consulting a professional to change your financial habits.

Which Debt Repayment Strategy Is Better?

While the prospect of debt forgiveness can make working with a debt settlement company a tempting option, debt consolidation is ultimately the safer and more beneficial choice in the long term.

If a debt settlement company asks you to stop making payments on your loan until your account becomes delinquent and they make an offer to your creditors, you run the risk of being rejected by the creditors and incurring a hefty amount of interest charges and late fees. You’ll also drive your credit score so low that it could take years for you to rebuild it enough to be approved for future lines of credit.

With debt consolidation, your financial standing will be far more secure so long as you consistently make the monthly payments you’ve committed to.

Options for consolidating your debt

If you decide that debt consolidation is your best choice, prepare to do some research. There are a few different consolidation options to consider.

Debt consolidation loans

These loans are personal loans for debt consolidation. You'll work with a lender providing you with a lump sum of cash, enough to pay off your existing debt. You'll use these funds to pay off your debt and then make monthly payments on your new loan – with interest – to repay your lender.

Debt management plans

A debt management plan is where you work with a company that negotiates with your creditors to create a payment plan you can afford. Each month, you'll make a payment to the debt management company, which in turn uses it to pay off your creditors. Debt management companies tend to be affiliated with nonprofit credit counseling agencies.

Home equity loans or lines of credit (HELOCs)

If you own a home, you can use a home equity loan or line of credit to tap into your equity or the difference between what you owe on your mortgage and what your home is currently worth.

For example, if your home is worth $200,000 and you owe $80,000 on your mortgage, you have $120,000 in equity. In a home equity loan, you'll receive a lump sum from a mortgage lender and pay it back in monthly installments.

A home equity line of credit (HELOC) works more like a credit card, with your credit limit based on factors like the amount of equity in your residence. You only pay back what you borrow during what's known as the draw period.

Credit card balance transfers

With balance transfers, you move the money you owe on one credit card to a new one with a lower rate. Many credit cards offer no interest on balance transfers for 6 – 12 months.

If you're taking advantage of an introductory period, you'll have a certain amount of time to pay off your transferred debt without having to worry about paying interest. The drawback? If you don't pay off your transferred debt before the introductory interest offer ends, the new card will charge its standard interest rate on the leftover balance.

The Bottom Line

While debt settlement and debt consolidation both have perks that can appeal to borrowers in need, consolidating your debt tends to offer less risk and provide better opportunities for repayment success over the long term. However, neither of these payment strategies is right for everyone, and they're not your only debt-reduction options. Look closely at your finances and spending habits before choosing one method.

If you're interested in pursuing debt consolidation, Rocket Loans^℠ can help! Prequalify for a personal loan that can help you consolidate your debt today.