There are many instances where debt is difficult to manage. In such situations, individuals are faced with two debt options, namely debt consolidation and debt settlement.
Although both debt consolidation and debt settlement aim to assist people with debts, their mechanisms of operation differ significantly. Debt consolidation is about combining multiple debts into one account, whose benefits include lower interest rates, simpler monthly payments, and fixed repayment plans.
On the other hand, debt settlement is all about negotiations with creditors for them to agree to accept less money than what was initially borrowed. It all depends on some of the factors mentioned above.
The main distinction between the two methods is in what they try to alter. Debt consolidation generally changes how you repay the debt, while debt settlement attempts to change how much of the debt you ultimately repay.
In the case of consolidation, a person will use a personal loan, balance transfer credit card or some other form of finance to repay their debts. Then, this person will have to make repayments in accordance with the terms of this new account.
In the case of settlement, the borrower, or even some debt settlement companies, negotiate with creditors for them to accept a smaller amount of money than was originally owed.
Other important differences include:
| Factor | Debt Consolidation | Debt Settlement |
| Primary objective | Consolidate debts and possibly lower interest rates or streamline the repayment process | Lowering the amount owed |
| Common procedure | Borrowing additional funds to settle previous debts | Trying to get the creditors to accept a lesser payment in exchange |
| Credit factors | This may be dependent on whether or not you have sufficient credit | It generally does not necessitate credit approval |
| Credit effect | This will temporarily affect your credit score through a credit check; however, making timely payments will help with credit in the long run | Delinquency, defaults, and settling your account can hurt your credit score significantly |
| Fees | Possible fees include interest rates, origination charges, balance transfer charges, among others | Charges from the settlement company and others |
| Debt amount | Remains the same amount of principal debt, although interest charges could be affected | Could result in lowering the amount needed to settle the debt |
| Key risk | Taking on new debt without changing spending or repayment habits | Credit damage, collection activity and unsuccessful negotiations |
In debt consolidation, one uses a new type of finance to pay off all their previous loans. Instead of making individual payments to different creditors, he will make payments towards his consolidation account.
They include:
The advantage of doing this is that you end up paying off your expensive debts by consolidating them into a much more affordable loan. For instance, a person having several debts and paying very high interest may consolidate them into an account with fixed interest and repayment periods.
Nevertheless, having low monthly payments is not always better because it means that the repayment period is long, hence paying more interest. Other factors like origination and balance transfer fees will lower the savings amounts. Additionally, it does not solve the underlying problem if more debts arise.
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The main benefits and drawbacks of debt consolidation are as follows:
There could be various advantages of debt consolidation:
There are also some limitations of the debt consolidation strategy. The first thing is that the person will not necessarily get approved for the plan. People with bad credit scores can have an interest rate with no actual benefits. Some plans include additional fees.
There is one more disadvantage: debt consolidation is not a process of wiping out the debt. This means that the debt will stay there; it will only be restructured. And if the person starts using the credit accounts again, the balance can be increased.
In debt settlement, negotiation occurs whereby creditors agree to accept lower amounts than the total amount initially owed by the individual. An individual may choose to do negotiations personally or use the services of a debt settlement firm.
Under many settlements, creditors are not allowed to receive payment until an adequate amount is set aside for settling the debt. This money can later be used to pay off the debt through a negotiated lump sum. However, non-payment may lead to late charges, collections activities, default, and bad credit reports. Creditors are not obligated to accept the settlement offers.
Should the settlement be agreed upon and the negotiated amount paid, then the creditor takes it as debt settled according to the terms of the settlement. However, the debt may be reported as settled for an amount lower than the total amount of the debt.
The pros and cons of debt settlement are as follows:
The following can make debt settlement relevant when a person is unable to pay the entire amount under the current terms.
Advantages include:
These can be quite serious. Late payments can negatively impact the credit score, and the issue of debt collection or even legal action might arise. Moreover, there is no guarantee of settlement.
Fees can also be considered. The fee structure can vary from company to company and region to region. Sometimes, there are also separate fees for account management. In certain regions, debt forgiveness can have tax consequences.
It would be difficult for people who have bad credit to consolidate their debts because, when evaluating applications for loans, lenders consider various factors including credit history, income levels, size of the debt, and many others. Besides, even if a person is granted a loan, the probability of having an excessively high interest rate should be taken into consideration.
At the same time, settlement does not require a person to get an additional loan; therefore, credit rating is not important at all during this process. However, people who are considering settling their debts should keep in mind that they might have bad credit due to their financial issues, and that the process of settling will make it worse.
Therefore, people who have bad credit should think about other ways first.
The use of credit card debt falls under both approaches due to the possibility of having relatively high interest rates and revolving credit.
A loan consolidation becomes an option when the borrower is eligible for a better product and can afford the new payment schedule. The balance transfer will offer a promotional interest rate too; however, this must also be determined based on qualifications, fees, and the term of the promotion.
The approach of loan settlement takes on a new dimension when the credit card debts have become a burden that the borrower is unable to keep up with through the necessary payments. As settlement involves credit problems, it usually does not equate to consolidation as just another means of reducing interest.
Consider the total cost, including the interest and fees, before deciding on either approach.
Impact on credit is perhaps the most significant difference between debt consolidation and debt settlement.
An application for consolidation may lead to a hard inquiry on credit history, and creating a new credit line may affect one’s credit score temporarily. Nonetheless, in the long run, proper payments and reduced utilization of revolving credit lines could help maintain good credit, based on individual credit profile.
However, debt settlement may affect credit history significantly since such actions are likely to include delays in payments or even defaults. Settled accounts will be reflected on credit history differently than accounts that were repaid under the original terms. The negative entries associated with delayed payments and other derogatory events could stay on credit history for years.
Both costs need to be evaluated before making any decision.
The debt consolidation fees could include loan origination fees, balance transfer fees, closing costs, or any other kind of fees based on the kind of financial product. The rate of interest is also an essential factor, as a lower monthly payment does not necessarily mean that the overall cost will be lower, as repayment of the loan takes longer.
Debt settlement fees depend upon the provider and the plan. While the settlement firm charges the customer based on a percentage of the debt owed or any other fee, the arrangement might also incur administrative expenses. Taxes on forgiven debt also have to be taken into account wherever applicable.
A good way of comparison is:
Total Cost = Principal Repayment Amount + Interest Amount + Fees + Taxes (if applicable)
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The fundamental difference between the two concepts lies in their nature, with debt consolidation typically involving the restructuring of debt and settlement attempting to lower the amount owed.
Debt consolidation can provide easier repayments and even cut down interest, but this needs to be done on appropriate conditions and in a manner that will allow for repayment of the new debt. Debt settlement can result in a reduction in the amount necessary to settle some of the debts, but there could be substantial credit, financial and legal implications for this.
Before settling on any of these methods, consider the interest rate, cost, amount payable, impact on credit and other options open to you in your jurisdiction.
Not always. Settlement can decrease the total owed, but other factors such as the fees charged, the cost of missed payments, interest charges, collection actions, and taxes might influence the ultimate cost of settling. Consolidation could turn out to be cheaper because a borrower can qualify for a lower interest rate and manage to settle the debt on time.
Yes, it can be. The process of settling debt normally involves missing payments, which leads to being late on payments, default, or even collections, and all these things will have a negative impact on one’s credit report for quite some time.
Debt consolidation can adversely affect one’s credit score temporarily. Making an application for a consolidation loan or credit card can bring about a hard inquiry, and having another credit account can affect various aspects of credit.
There is no universal answer because the two approaches address different financial situations. Compare your ability to make payments, credit profile, interest rates, total costs, fees, and the consequences of becoming delinquent before deciding which strategy fits your circumstances.
Consider the underlying problem first. Consolidation may be relevant when you can afford repayment but want to simplify multiple debts or potentially reduce interest. Settlement may be considered when existing payments are no longer affordable and negotiating reduced balances is a realistic alternative to other forms of debt relief.
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