What is Debt Consolidation?
Debt consolidation combines multiple debts into a single loan, often with a lower interest rate.
The goal of consolidating debt is often to simplify monthly payments or reduce your interest rate. For instance, someone with $20,000 in credit card debt spread across three cards with an average Annual Percentage Rate (APR) of 18% might get a lower-interest personal loan at 10% APR to pay them off.
After consolidation, they'll have one monthly personal loan payment instead of juggling several high-interest credit card payments, potentially saving money on interest and simplifying their debt management.
Banks, credit unions, and online lenders offer debt consolidation loans. While many people consolidate debt with a personal loan, other types of financing, such as home equity loans, can also be used for this purpose. Debt consolidation loans can be unsecured, meaning no collateral is required, or secured, meaning collateral is required.
We’ve researched the best debt consolidation loans in depth to find the best solution for your situation.
Debt Consolidation Pros and Cons
Pros:
Simplified monthly payments
Potentially lower interest rates (average reduction of 5-10%)
Maintained or improved credit score if payments are made on time
Cons:
May require good credit (typically 660+ FICO score)
Risk of accruing more debt if spending habits don't change
What is Debt Settlement?
With debt settlement, you or a third-party service negotiates with your creditors to settle your debt for less than you owe. A typical settlement might be 50% of the original debt amount. While reducing your debt might sound ideal, it comes at a cost: Debt settlement damages your credit significantly, and settled accounts stay on your credit reports for seven years.
There’s also no guarantee that your creditors will accept a lower payment. Even if they do, you may need to pay your remaining balances as a lump sum, which could be difficult if you’re struggling financially. Fees often apply if you work with a debt settlement company.
Debt Settlement Pros and Cons
Pros:
Reduces total debt amount (average savings of 20-50%)
Can help avoid bankruptcy
Cons:
Significant negative impact on credit score (typically 100+ points)
Settled debts are usually taxable as income
Fees can be hefty (15-25% of enrolled debt)
Debt Consolidation vs. Debt Settlement: Key Differences
Financial situation: Those considering debt consolidation generally have more manageable debt and better credit than people looking into debt settlement.
Credit score impact: Debt consolidation doesn’t significantly harm your credit score, but settlement could seriously hurt your credit.
Costs: Many lenders charge an origination or application fee for a debt consolidation loan, but that’s a one-time, often nominal cost. Debt settlement could cost more in fees and taxes, as settled debt is taxable.
Timeframe: Paying off consolidated debt might take several years, depending on your balance. The debt settlement process typically takes 24-48 months.
Beyond Consolidation and Settlement: Other Debt Relief Options
Credit Counseling
Non-profit agencies offer free or low-cost advice and can help create a debt management plan tailored to your needs. According to the National Foundation for Credit Counseling (NFCC), 67% of their clients reported being better at managing money after counseling.
Debt Management Plans (DMPs)
These plans, often arranged through credit counseling agencies, can lower your interest rates and consolidate payments without taking out a new loan. The NFCC reports that clients on DMPs typically become debt-free in 3-5 years.
Bankruptcy
While often seen as a last resort, bankruptcy can provide a fresh start for those with overwhelming debt. Chapter 7 bankruptcy can eliminate most unsecured debts, while Chapter 13 allows for a structured repayment plan.
Do-It-Yourself Debt Payoff Methods
Strategies like the debt snowball (paying off the smallest debts first) or debt avalanche (focusing on the highest-interest debts) can be effective. A study published in the Journal of Consumer Research found that people using the debt snowball method were likelier to eliminate their debt entirely.
How to Choose Between Debt Consolidation vs. Debt Settlement
Your choice between debt consolidation or debt settlement depends on your unique financial circumstances. Debt consolidation can be a good idea as it is generally less risky and better for your credit, while settlement can provide more immediate relief for overwhelming debt. Always research thoroughly and consider consulting a financial advisor before making a decision.
