Debt Relief vs. Debt Consolidation: Pros and Cons

If you’re weighing debt relief vs. debt consolidation, you’re probably looking for a better way to handle your debt. Maybe you can’t keep up with payments anymore, or you want to simplify the payoff process.

Debt settlement and debt consolidation are two common options, and they work in very different ways. Settlement attempts to pay off your debt for less than what you owe. Consolidation changes how you repay your debt.

This article explores the differences between the two, and offers debt relief vs. debt consolidation pros and cons. The right fit depends on factors like how much debt you have, your financial resources, and your credit. Both methods can impact your score, although debt relief normally has a greater impact.

In each case, the goal is to work through your current debt problems to get on a steadier financial course. Making the right choices about your debt is not only good for your finances—it could also do wonders for your peace of mind.

Debt Relief, Debt Settlement, and Debt Consolidation: What Each Term Means

These three terms get used loosely, and the differences matter to your decision.

Debt settlement is one form of debt relief. Debt consolidation is another. This article compares those two.

You May Like These

What Is Debt Resolution?

Credit card counseling pros and cons

Can You Get An Emergency Loan With Bad Credit?

Debt Consolidation vs. Debt Settlement in a Nutshell

Debt consolidation and debt settlement are different types of debt relief. In debt settlement, you or a debt relief company negotiate with creditors or debt collectors to reduce the unsecured debt you owe. Debt consolidation rearranges the debt without reducing the balance.

The right route depends on your situation, including your:

• Debt balances

• Credit score

• Payment status on your debts

• Ability to keep on top of your payments

If you're trying to get on top of your debts, learning about your options is the right place to start.

How Debt Affects Your Financial Health

Debt may be a useful financial tool in certain situations, like buying a home with a mortgage. Too much debt, especially high-interest debt, could weigh on every aspect of your finances.

Rising costs can already be a challenge for household budgets. Debt payments cut further into your budget. Credit card balances, in particular, often compound quickly because of high credit card interest rates.

Every dollar you borrow today reduces the money you'll have available in the future. Money you put toward interest charges is money you can’t use to grow your savings, build a nest egg for retirement, or work toward other financial goals.

This impact goes beyond just the dollars and cents. Too much debt may drag down your credit score, which could make it harder to get approved for loans, credit cards, and even home rentals.

And then there's the stress. High debt payments make it harder to afford the things you need, and it could become a strain on your mental health. A constant struggle to pay what you owe isn’t a problem to ignore. That's when it's necessary to change the pattern and work toward a solution like debt consolidation or debt settlement.

What Is Debt Consolidation?

Debt consolidation is a new loan or balance transfer credit card that you use to repay multiple existing debts. One benefit is that you reduce the number of payments you make each month. This could make it easier to keep track of your payments.

Beyond that, debt consolidation has several other potential advantages. You might:

• Lower your monthly payments, relieving strain on your budget

• Lower the interest rate you're paying

• Get a firm end date for the debt you consolidate (if you consolidate with a loan)

• Lower your credit utilization ratio, which could help your credit score

• Move variable-rate debt to a fixed interest rate

• Reduce the total amount of interest you pay (unless repayment stretches over a longer term)

So how does this work? The following are a few examples of how you might apply debt consolidation options:

Suppose you owe balances on several credit cards. Not only are you paying high interest on that debt, you're struggling to manage several payments each month. Moving those balances to a balance-transfer credit card would merge all those payments into one. Better yet, balance-transfer cards often offer 0% interest for a limited time. If you repay the balance within that time, you save on interest. The interest rate typically jumps up after the introductory 0% period ends, and most balance transfer cards charge a balance transfer fee of 3% to 5%.

You may decide repayment could take longer than the 0% interest period on a balance transfer card. If so, a personal loan is another option for debt consolidation. Personal loan interest rates are generally much lower than credit card rates, especially if you have good credit. A loan also gives you predictable monthly payments and a definite end date. That certainty could make it easier to plan your budget than when you have variable credit card payments.

Let's say you're a homeowner. Between paying your mortgage over time and the rise in real estate prices, you've built up a decent amount of equity in your home. You also have a personal loan and a few credit card balances. In addition to managing multiple payments, you're paying relatively high interest rates on these other debts. You could take out a home equity loan to repay them. That would simplify your payments, and would likely leave you with a lower interest rate. The tradeoff is that your home secures the loan, and if you don’t make the payments, you risk foreclosure.

The common thread in all these examples is that debt consolidation does not reduce the total amount you owe. It restructures your debts to make them more manageable. In some cases, that could reduce the amount of interest you pay over time.

Debt consolidation works best if your credit is strong enough for approval on a new loan. It's less realistic if missed payments have significantly damaged your credit.

Advantages and Disadvantages of Debt Consolidation

In some situations, debt consolidation could be an efficient way of making debt more manageable. Understanding the advantages and disadvantages to debt consolidation could help you determine whether it's the right fit for your situation.

Debt consolidation advantages

Here are some advantages of debt consolidation:

• It makes managing monthly payments easier by merging multiple payments into one.

• It could make monthly payments smaller by reducing your interest rate and/or spreading repayment out over a longer time.

• You could reduce the total amount of interest you pay over the repayment period. Lowering your interest rates and/or picking a shorter repayment term could make this happen.

• Consolidating credit card debt into a loan could give you a firm timeline for repayment.

• Upfront credit impact is typically minor. In the long term, there's potential for positive impact from making payments more manageable and potentially lowering credit utilization.

Debt consolidation disadvantages

• Generally, it takes a solid credit history to get new credit. If yours has been seriously damaged, you may have trouble with approval for a debt consolidation loan or a balance transfer credit card.

• There may be fees associated with a loan or a balance transfer card. Balance transfer offers also expire after a set time period.

• Debt consolidation doesn't reduce the total amount you owe. It could make payments more manageable, but if your debt has gotten out of hand, that may not be enough to make them affordable.

• Debt consolidation may stretch repayment over a longer time. This could increase your total cost over the repayment period.

• Debt consolidation works best as part of a broader budget and debt reduction plan. Without one, credit card balances repaid by a consolidation loan could build back up.

Debt consolidation is generally a good fit if you've recognized the problem early. It's more likely to work if your options aren't limited by credit problems.

When Should You Consider Debt Consolidation?

Debt consolidation makes the most sense when:

• You can qualify for a new, lower-interest loan or balance transfer card that covers high-interest debts, like credit cards.

• You have a plan to avoid running up new balances after debt consolidation.

• You can afford your current debt payments and want to reduce your interest costs or simplify repayment.

A budget that covers everyday expenses is key. Without one, new balances could accumulate on the cards you just paid off, on top of the consolidation loan or balance transfer card itself. If you don’t have a budget yet, learn how to get started budgeting.

What Is Debt Settlement?

Debt settlement is when you or a debt relief company negotiates to reduce the amount you owe. It’s designed to help when you find yourself with an overwhelming amount of unsecured debt, such as credit card balances, personal loans, and medical debt.

A debt relief company charges a fee for any debt they settle, typically a percentage of the debt settled. Under federal law, debt relief companies can only collect a fee after they’ve settled a debt, you’ve approved the settlement, and you’ve made at least one payment on it. The advantage is that debt settlement professionals have usually been through the process many times before. This may help them negotiate a better settlement than you'd get on your own. That may make it more than worthwhile to pay the fee.

Whether you hire a professional or go it alone, having a plan is better than just ignoring the debt. Ignoring your debts could result in bill collectors contacting you, missed payments damaging your credit score, and interest and fees accumulating.

The better way is to contact your creditors and try to work something out. Creditors would like you to pay the full amount you owe. They also weigh the time and cost of collection on debts a borrower cannot repay. If you can demonstrate to a creditor that there's no way you could pay your debt in full, they might agree to accept a lesser amount.

This works best with unsecured debt. If you owe secured debt, the creditor typically has the option to claim the collateral rather than accepting less than you owe.

Debt settlement also works best if you have a specific offer. As soon as you decide to try settling your debts, build up whatever amount of savings you can. If you work with a debt settlement professional, building up that kind of settlement fund is likely to be part of the program.

This settlement fund becomes the money you could offer your creditors. That way, even though it's less than the full amount you owe, the creditor may be swayed by the idea that they could collect money for the unpaid debt right away. The fund stays in your name. You own and control the account.

Debt settlement does show up on your credit report and impact your credit score. When a debt is reported as “settled,” that's less favorable than “paid as agreed.” Still, by the time people decide to settle debts, they've usually already damaged their credit. After debt settlement, the work to rebuild credit could begin.

There's another possible consequence: Forgiven debt is usually considered taxable income, and would be subject to income taxes in the year the settlement agreement is reached. If you qualified as insolvent (your financial liabilities are greater than your assets) immediately before the debt was canceled, you may not have to treat forgiven debt as taxable income. The IRS explains how canceled debt is taxed.

The key is to get your debt down to a level where you may be able to afford to make all your payments on time every month. At that point, you're better positioned to build up your credit score.

How Debt Relief and Debt Consolidation Affect Your Credit

Credit impact is one of the clearest differences between these two options.

With debt consolidation, the application typically causes a small, temporary dip from the hard inquiry. If you consolidate debt with a loan that repays your credit card balances, your credit utilization ratio generally drops, which could help your score. On-time payments on the new loan (or balance transfer card, if you consolidate debt that way) then build a positive history.

With debt settlement, some people have already missed payments and seen their credit scores drop before they enroll. Accounts that go delinquent during the program typically lower a score further, and each resolved account is reported as “settled” rather than “paid as agreed.” Negative information generally stays on a credit report for up to seven years.

After a settlement program ends, you can focus on rebuilding your credit by making on-time payments on any remaining debt accounts and keeping your balances low going forward.

Pros and Cons of Debt Settlement

Is debt settlement the right solution for your needs? Here are the pros and cons of debt settlement.

Debt settlement pros

• It could reduce the total amount you'll have to repay.

• Your monthly deposit into a debt settlement account could be lower than the combined minimum payments on your debts.

• Once a debt is settled, interest and fees stop accruing.By wiping out part of your debt, debt settlement also reduces the amount of interest you'd owe in the future.

• Debt settlement programs typically have no minimum credit score.

• Debt settlement could provide more control than bankruptcy, where a bankruptcy court handles your case.

• Debt settlement gives you the option of negotiating for yourself or hiring professional help.

Debt settlement cons

• It typically only works with unsecured debts (those without any collateral).

• Your credit score is likely to drop, especially if you choose to stop making payments during the debt settlement process.

• You have to commit to saving to build up a debt settlement fund.

• If you work with a debt settlement professional, fees reduce your savings from settled debt.

• Creditors and debt collectors could continue collection efforts during the program, and there’s no guarantee of settling your debt.

• Forgiven amounts may be subject to taxes.

Debt settlement may be worth considering if you have a lot of unsecured debt, like credit card debt. It may be worth checking out if your credit score is too damaged for you to be approved for new credit. It might also help if you couldn’t afford to pay your debts even with more time to pay or a lower interest rate.

When Should You Consider Debt Settlement?

Debt settlement makes the most sense when:

• You've already considered other solutions like tighter budgeting or debt consolidation.

• You have a financial hardship that leaves you no realistic way of fully repaying your debts.

• You've already fallen behind, or you're at risk of falling behind.

Maybe you've tried cutting unnecessary expenses, and still can't make your money stretch far enough to cover your essential costs. Perhaps you've considered debt consolidation, and found it wouldn't lower your payments enough. Maybe you weren't approved for new credit to consolidate debts.

Debt settlement isn't quick or easy. You have to have something to offer your creditors. To save up money for offers, many people choose to stop paying their debts. And any time you stop paying your debts, you should expect a negative impact on your credit standing. Late and missed payments stay on your credit report for up to seven years.

Even so, settling debt could put you in a better position to rebuild your credit and move toward a better financial future.

Debt Settlement vs. Debt Consolidation: A Side-By-Side Comparison

Think of debt consolidation and debt settlement as tools for different situations. Which strategy is better for you depends on your needs and circumstances. Here's a rundown of some of the key differences between debt consolidation and debt settlement:

Which Option Saves More Money?

So what's the answer? Which option could save you more money on your debt? There's no immediately clear answer until you've reviewed the financial impact on your situation.

When you consider these options, there's more than one way to define that financial impact. Recognize all three potential areas of cost and savings when making your decision.

The amount you owe

Debt consolidation does not reduce the total amount you owe. It only revises the repayment terms of that debt. Debt settlement could reduce the total amount of unsecured debt you owe.

Interest costs

Debt consolidation could reduce your interest costs by lowering the interest rate you're paying on debt. It could also save you interest if you choose a shorter repayment period, provided you can afford the larger monthly payments that may be required. If you choose a longer repayment term, that could increase the total amount of interest you pay, even if you get a lower rate.

Debt settlement is a negotiation on the balance you owe, including the principal and interest. Interest and fees could continue growing until you settle a debt. If a debt is forgiven, you don't pay interest on that debt going forward, which lowers your total interest cost. This is especially true since debt settlement works best with unsecured debt, which usually has relatively high interest rates.

Fees

For debt consolidation, there may be fees associated with a loan or a balance transfer card. These fees are typically a small percentage of the amount involved.

By federal law, debt settlement only costs you a fee once part of your debt has been cancelled. That fee is based on the amount of debt enrolled into the debt settlement program.

Alternatives to Debt Consolidation and Debt Settlement

Debt consolidation and debt settlement aren't the right debt solutions in every situation. Here are some other ways to manage overwhelming debt:

• Credit counseling: Credit counselors could help you organize your budget and come up with a strategy to repay your debt. A good first step if you feel overwhelmed by debt is to have a credit counselor explain your options.

• Debt management plan (DMP): You work with a credit counselor to create a plan to repay your debts. Your counselor then works with creditors on your behalf to set up a repayment plan. The goal is to make your payments manageable. Once the DMP is in place, you make a single monthly payment to the credit counselor, who will split it between your creditors.

• Bankruptcy: Bankruptcy is a legal process that takes place in court. You may be able to reorganize your debts, or even have some of your debts discharged. The two most common types of bankruptcy for individuals are Chapter 7 and Chapter 13. Bankruptcy may be the right move if you've tried other methods, and just don't have a way to make all your payments.

• Repay the debt on your own: You could follow a plan to repay your debts without a program. These plans usually require that you make some sacrifices and cut back on spending.

• Debt snowball method: This is one way of organizing your payments. It involves putting any extra payments toward your smallest debt first. That provides motivation since you resolve the smallest debt the fastest, getting rid of one payment. It doesn't help you reduce your overall debt faster, but some people find it a helpful way to organize payments and keep going.

• Debt avalanche method: This is another approach to organizing payments. It directs any extra payments towards your highest-interest debt first. By targeting that debt first, you save more on interest in the months that follow. This means more of your payments go toward principal, and that allows you to reduce your overall debt faster.

Debt Relief vs. Debt Consolidation: How to Decide

To decide on the right way to manage your debt, take a close look at how each method could affect your situation. Think about what you'd most like to accomplish. If your debt feels unmanageable, you may have different goals than someone who simply wants to pay less credit card interest.

Consider more than just reducing your monthly payments. Factor in the total debt costs, the amount you'd pay in fees, and the impact on your credit score. That way, you can decide which strategy could leave you better off, now and in the future.

If unsecured debt is the core of the problem and full repayment isn't realistic, debt settlement may be worth exploring. If your credit is intact and high interest is the main issue, debt consolidation is generally the better starting point.