There’s nothing easy about having thousands of dollars in debt hanging over your head – and the path to getting rid of it can be complicated and littered with jargon.
Debt consolidation and debt settlement are two popular methods to settle and repay substantial debts. Each comes with different risks, and there are several factors to weigh when choosing which is right for you.
The good news is that once you’ve taken that first step to begin exploring options, sorting through them can turn out to be easy by comparison, according to Erica Sandberg, consumer finance expert at BadCredit.org.
“You’ve got this debt sitting on your chest,” Sandberg told The Post. “Typically, the debt is large, but your ability to pay is small, so you feel stressed. There’s simply not enough money to go around, and it becomes this sort of anxiety-build experience.”
So what are debt consolidation and debt settlement, and which is the right choice for you?
What is debt consolidation?
Debt consolidation is pretty much what it sounds like – a way of bundling all of your debts with a new lender into a single loan or credit card.
“They kind of work in different ways, but each new lender would absorb the old stuff and you’d have totally new terms – new interest rate, new payments and just a completely new card or loan,” Sandberg said.
A new loan will give individuals with multiple unpaid credit cards and loans a single monthly payment to cover.
A balance transfer credit card, meanwhile, will move all of your outstanding debt to a new card that typically has a lower interest rate or an introductory 0% APR.
This is a good option for individuals with debt on multiple credit cards – for example, outstanding balances on a card with a 29% interest rate and a card with a 21% rate – since the new card will lower the interest you’re paying each month, Sandberg said.
Another option for those looking to tackle their debt is to make an appointment with a nonprofit credit counseling agency.
Counselors will comb through your budget and calculate how much you need to spend on monthly expenses, as well as how much you should have left over to go toward your debts.
The agency would then arrange for you to make one monthly payment. You’ll send your monthly payment to the agency, which will distribute the money to your multiple credit card companies or lenders.
For those considering debt consolidation, taking out a new loan is typically a better choice for debtors with a larger sum of debt, like many thousands of dollars.
A balance transfer credit card, on the other hand, is better suited for those with just $1,000 or $2,000 in debt.
A nonprofit counseling organization is a good choice for individuals who believe they can manage a new monthly plan, since it’s a free service, Sandberg said.
However, it does not involve repackaging your debt, so you won’t enjoy a lower interest rate.
Whether it’s a loan, balance transfer credit card or debt management plan, all these forms of consolidation have one aim – and that’s to get out of debt within a certain time frame.
What is debt settlement?
Debt settlement, on the other hand, has a completely different goal – to avoid paying the full amount of money owed.
This involves negotiating with your debt collectors – perhaps offering to pay $5,000 today on debts totaling $10,000 if they’ll forgive the rest, Sandberg told The Post.
While it’s possible, it’s not terribly common for debtors to successfully negotiate with their current credit card companies or lenders, she added.
That’s when a debt settlement company – which will do the negotiating for you – comes into play. The company makes its money by taking a cut of the eventual settlement.
However, debt settlement is a risky process.
These firms will normally instruct you to stop making payments on your loans and credit cards, instead funneling that money into a separate account that will theoretically be used to pay the final settlement.
That process can tank your credit score, and there’s no guarantee a company will be able to reach a settlement with your lenders in the end.
Pros and Cons of Debt Consolidation and Debt Settlement
Debt Consolidation
Pros:
- Simplifies Debt Management: Combines multiple debts into a single payment.
- Lower Interest Rates: Can reduce overall interest, especially with a balance transfer card or loan.
- Credit Score Protection: Helps maintain or improve credit if payments are made on time.
- Structured Repayment Plan: Encourages disciplined, scheduled payments.
Cons:
- Requires Good Credit: Approval depends on a fair to good credit score.
- Upfront Fees: Loans may charge origination fees, and balance transfers often have fees.
- Not a Debt Reduction Strategy: You still pay the full amount owed, just under different terms.
Debt Settlement
Pros:
- Reduces Total Debt Owed: Potentially lowers the principal amount due through negotiations.
- Avoids Bankruptcy: Can be a last resort before filing for bankruptcy.
- One-Time Settlement Option: If successful, it provides a faster path to debt relief.
Cons:
- Damages Credit Score: Missing payments to negotiate a settlement can severely impact credit.
- No Guarantee of Success: Creditors are not required to accept a settlement.
- Settlement Fees and Tax Implications: Companies take a cut, and forgiven debt may be taxable.
Which process is better for you?
Debt consolidation is typically a better choice for individuals with fair to good credit scores, since they’re more likely to get approved for a new loan or balance transfer credit card.
Debt settlement is a better choice for debtors with poor credit scores in more dire situations, perhaps trying to avoid bankruptcy, since they’ll struggle to gain approval for new loans or cards.
The last thing an individual with a lot of debt should do is apply for a card that they likely won’t gain approval for since the application itself will further hit their credit score, Sandberg said.
Debt consolidation also usually requires an upfront payment.
A new loan may charge an origination fee – say a $500 charge to consolidate $10,000 in debt, said Sandberg.
The ability to afford this upfront payment is another factor in choosing debt consolidation.
Now you’ve paid off your debts. How can you avoid past habits?
Once you’ve paid off or settled your debts, avoiding falling into familiar habits is important.
Credit cards can often feel like supplemental income, especially for low-income individuals.
So you might end up using your credit card for things you can’t afford, and that can quickly pile up.
“Really look at credit cards in a completely different way. Look at them as a payment tool, not as a loan,” Sandberg said.
“Knowing, absolutely knowing, that when you go to Safeway or the drug store, you know that when you make that purchase [for] $300, you’re gonna be paying $300 in a few weeks.”
And if you do choose to push some of your credit card bill onto the next month, do it as infrequently as possible and with a plan, she said.
You might want to overspend one month to afford a vacation, for example, including plane tickets, a hotel and a nice tour, Sandberg said.
While you might not have $2,000 to pay off the full vacation at the end of the month, you could plan to pay it off in $500 increments over a few months, Sandberg added. And that might be worth the relatively small amount of interest you’ll end up paying.
What is the current debt situation in the US?
Rising interest rates and stubborn inflation in the years following the pandemic have only worsened consumer debt.
Household debt hit $18.04 trillion in the fourth quarter of 2024 – a record high, according to the Federal Reserve’s quarterly report on debt and credit.
