Debt Consolidation vs. Debt Settlement: Which Is Best for You?

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Updated on Monday, October 29, 2018

debt consolidation or debt settlement

Non-mortgage consumer debt in the U.S. recently rose to $3.935 trillion, a 6.2% increase over a year ago. This rise could result in more consumers struggling with managing their debt.

Fortunately, there are options available to help ease the financial pressure of juggling multiple debts. If you are a consumer in need of help with managing your finances, you may be wondering which of those options is best for you.

In this article, we’ll review two debt relief solutions: debt consolidation and debt settlement. We’ll cover how they work, how they compare with each other and which one is best in your situation.

Debt consolidation vs. debt settlement

 Debt consolidationDebt settlement

What is it?

A strategy that combines multiple debts into a single loan or credit card.

A service typically offered by for-profit companies in which they attempt to negotiate and settle your debts on your behalf..

How much does it cost?

Depending on which method is used for consolidation, costs can include an origination fee, balance transfer fee, points or an application fee.

A percentage of the total debt settled or the amount saved, typically 15% or more.

When is it useful?

To pay off high-interest debts and eliminate the need to juggle multiple payments.

To resolve debt if you have been unsuccessful with other attempts.

Are there credit requirements?

You can qualify for some loans even with a low credit score, but higher credit scores will yield the best interest rates and most favorable terms.


Can you continue to use your accounts?


No. You will need to close the accounts.

How long does it take?

It depends on the terms of the new loan or credit card, the amount consolidated and the monthly payments.

It varies. Companies can wait several months or even years before they attempt to negotiate with your creditors.

Are there tax implications?

Typically no, unless you use a 401(k) loan to consolidate and it is not paid back as agreed.

You may be responsible for taxes on the forgiven portion of the debt.

Will it affect your credit?

A new loan or credit card will have an initial negative impact on your score, but it should improve as you pay down the loan.

The debts will be identified as “settled,” which is a derogatory mark.

Is it guaranteed to work?

Yes, if you are approved for the new loan or credit card, you can pay off your old debts with it.

No. Some creditors may not negotiate with debt settlement companies.

What is debt consolidation?

“The basic idea [of debt consolidation] is you take a bunch of debts that you already have, and you pay them off with one new bigger debt,” said Andrew Pizor, a staff attorney at National Consumer Law Center. It can be achieved in multiple ways, from taking out a personal loan to using a credit card.

The goal in combing the debts is to do so at a lower interest rate than you are paying on the individual debts. Ideally, this results in a lower monthly payment and the ability to pay off your debt at a faster rate.

Having a single monthly payment can also make it easier to manage your bills, but Pizor said that should not be the primary motivation for consolidating debt.

“Some places advertise debt consolidation by saying, ‘Make one easy payment,’ but just having one payment versus multiple payments, by itself, is not a reason to do it,” Pizor said. “If your problem is you can’t write five checks or do five online bill payments instead of one, then debt consolidation isn’t going to solve your problems.”

It’s important to keep in mind that debt consolidation does not reduce the amount of debt owed. Instead, it moves the debt to a new vehicle.

How does it work?

Consumers can consolidate most types of debt including:

  • Credit cards
  • Student loans
  • Unsecured personal loans
  • Business debt
  • Medical bills
  • Debts in collections
  • Taxes

And there are multiple ways to approach debt consolidation including;

  • Debt consolidation or personal loan
  • Credit card balance transfer
  • Home equity loan
  • Home equity line of credit (HELOC)
  • Cash-out refinance on your mortgage
  • 401(k) loan

Who is it useful for?

Since one of the most significant benefits of debt consolidation is the potential to pay less interest, and in turn have a lower monthly payment, this strategy is best suited for those who have high-interest debt but would qualify for a low rate.

Additionally, consumers with consistent income who have a decent grasp on their finances and are confident they can handle the new payment are good candidates for debt consolidation. Pizor cautioned that it’s not a good solution for consumers who are behind on their bills. “It’s not a silver bullet by any means,” he said. “If you’re behind on your bills, your budget is probably more your problem.”

How much does it cost?

The cost of debt consolidation depends on what approach you use to consolidate the debt. Whatever costs are associated with the new loan — balance transfer fee, an origination fee, points, an annual fee, etc. — contributes to the price of the consolidation.

How long does it last?

The length of debt consolidation also varies by what is used as the new loan as well as the total amount of debt and the size of your payments. If you use a personal loan, your consolidation will last the term of the loan (unless you pay it off early), but if you use a credit card and only make the minimum payments, you could be paying for a much longer time.

When should you use it?

Debt consolidation is best used to reduce the amount of interest you’re paying so that more of each payment can go toward reducing the balance on the debt and paying it off faster. Again, it is not a good strategy if you’re having trouble paying your bills.

What to watch out for

Consolidating your debt can provide relief, but there are some things to watch out for.

  • Paying more on no- or low-interest debts. If you consolidate debts that have no or low interest, you may ultimately increase how much you pay in interest.
  • Extending the term of your debt. Your lower monthly payment may come with a longer term than the individual debts, and in the end, more interest paid over the life of the new loan.
  • Putting your home at risk. If you consolidate unsecured debt such as credit card and medical bills with a home equity loan or HELOC, you are putting your home in jeopardy should you have trouble paying the new loan.
  • Going deeper into debt. You’ll be freeing up the balances on some of your debt leaving the potential to run them up again.
  • Losing protection on federal debt. If you consolidate federal student loans into a new loan or credit card, you lose any rights and options associated with them.

What is debt settlement?

Another debt relief option available to consumers experiencing financial strain is debt settlement. “The concept of debt settlement is that you ask your creditors to take less than what you owe them usually in return for some kind of lump-sum payment,” said Pizor.

Companies that provide debt settlement as a service do the negotiating and settling of your debts on your behalf. They tout their ability to reduce the amount you owe significantly and help you pay your debt off faster.

How does it work?

When you enroll in a debt settlement program, you usually are encouraged to stop paying your bills and sometimes to even stop communicating with your creditors. During that time, you make monthly payments into a separate account that is dedicated to settling your debt.

After enough money has accumulated in the account, the debt settlement company then uses the funds to offer your creditors a lump sum that is lower than the balance due. The reason your creditors may agree to a smaller amount is that payment has been withheld for so long that they are willing to accept less than what is owed rather than continue to go unpaid.

Only unsecured debt such as credit cards, medical bills, collection items, some student loans — and other debts that are not attached to an asset — are eligible for a debt settlement program.

Pizor said he advises consumers against using debt settlement companies because the chances of coming out ahead are slim to none. Creditors are not required to talk to third-party services, and in some cases, many do not.

Additionally, Pizor cautioned that the method that debt settlement companies use has many consequences. “You can get sent to a collection agency; late fees and penalties accrue; interest increases; they can sue you and it hurts your credit report.”

Instead, he said consumers should communicate with their creditors directly.

Who is it useful for?

Consumers who are already delinquent with their debt may consider looking into debt settlement. However, the high fees and potential tax implications could reduce any benefit of working with a debt settlement company.

Pizor stressed that consumers can negotiate and work with their creditors on their own. “If people have trouble with their payments, I encourage them to call their creditors and try to work something out.” That approach is likely to yield better results, and there are no fees associated with negotiating your own debt.

How much does it cost?

The fee for debt settlement is typically a percentage of the original balance enrolled in the plan or the amount settled, which can be around 15%. If you have a total of $20,000 enrolled in a debt settlement plan, then your fee is $3,000. You may be required to pay this fee whether or not the company is successful in negotiating your debt.

How long does it last?

Debt settlement plans can typically take around three years to complete, but the length will vary depending on how much total debt you have enrolled.

When should you use it?

Debt settlement is targeted at consumers who are extremely behind on their bills and to those who want to avoid bankruptcy.

What to watch out for

  • Fraudulent companies. Some companies make legitimate attempts to settle a consumer’s debt, but many prey on vulnerable consumers by making false promises and charging fees upfront.
  • Potential tax implications. If your debts are negotiated successfully, the amount that is forgiven could be taxable.
  • High fees. The amount paid to a service could be better used reducing your debt.
  • Your situation may get worse before it gets better. Because your accounts will go unpaid for quite some time, you could be hit with additional fees and interest, sent to collections or sued.
  • It may not work. There is no guarantee your creditors will work with the debt settlement company that you hire, so you could potentially be paying into a process that won’t work.

Should you use a debt consolidation loan or debt settlement?

When considering these two options, think about the state of your current finances and what you ultimately want to accomplish.

Debt consolidation loans could be a good solution for tackling high-interest debts and for positioning you to pay off your debt faster. “If you’re very careful about it, it can help you manage your money,” Pizor said.

If you are considering debt consolidation, make sure you can comfortably afford the payment on the new loan.

For consumers who are severely behind on their bills or are looking to negotiate their debt, again, you can communicate directly with your creditors before entering a debt settlement program. If you believe a debt settlement program is for you, proceed with caution.

Next steps

If you decide you want to pursue one of these options, take the following steps.

Debt consolidation

  1. Research your loan options. Spend some time looking into the best ways to consolidate your debt. Review the products your existing bank has available, but also consider looking into credit unions, community banks, and online lenders.
  2. Get preapproved. Some lenders offer preapproval in minutes online.
  3. Compare loan terms and choose your loan. Look at the rates and fees of various loan options or credit cards. Be sure to examine the APR when comparing loans side by side. Choose the option with the most favorable terms and a payment you can afford.

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Debt settlement

  1. Do your homework. Research the debt settlement company via the Better Business Bureau, your state attorney general or local consumer protection agency. Avoid doing business with a company that guarantees specific results or charges for their services upfront. Also, find out ahead of time if your creditors will work with a third party.
  2. Read the fine print and ask a lot of questions. According to the FTC, debt settlement companies must disclose the following:
    • Price and terms: The company must explain its fees and any conditions on its services.
    • Results: The company must tell you how long it will take to get results — how many months or years before it makes an offer to each creditor for a settlement.
    • Offers: The company must tell you how much money or the percentage of each outstanding debt you must save before it will make an offer to each creditor on your behalf.
    • Nonpayment: If the company asks you to stop making payments to your creditors — or if the program relies on you to not make payments — it must tell you about the possible negative consequences of your action.
  3. Compare the costs of multiple programs.
  4. Get the terms of your agreement in writing.

Consider all your options

Before jumping into any one solution, be sure that it will work for you in the immediate future as well as long-term, and again, make sure you can afford it. “Before you think about it, you really need to look at your budget overall to see where your money is going and see what you can afford,” Pizor advised.

Also, Pizor said anyone experiencing financial difficulty should consider talking to a nonprofit credit counselor before deciding on a debt relief option. They will be able to provide you with an objective look at your situation.

Regardless of which method you choose, set yourself up for success by setting up automatic payments and taking any other necessary precautions to avoid falling behind or becoming overwhelmed again.

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