Debt consolidation vs debt settlement: Which is right for you?

If you feel like your debt is holding you back, you're not alone. The average American debt has steadily increased since 2021.

Fortunately, there are several options for debt relief, two of which are debt consolidation and debt settlement. Understanding how each program works and its risks is essential to deciding which is appropriate for your situation. 

Debt consolidation vs debt settlement

Debt consolidation combines multiple debts into a single monthly payment via a consolidation loan or a balance transfer credit card. Meanwhile, a debt settlement is an agreement you reach with your creditors to reduce the total amount of debt you owe.

What does debt consolidation mean?

Debt consolidation may be right for you if you have various high-interest debts, and it's relatively simple to do on your own. Debt consolidation reduces the number of accounts you owe. This means transferring all your outstanding debt to a single line of credit, like a personal loan, balance transfer card, or home equity loan.

How a debt consolidation program works

One of the advantages of a debt consolidation program is that you pay off all your bills, so you no longer have to answer to multiple creditors. You'll also be paying one bill each month instead of various accounts. Additionally, the best debt consolidation loans tend to have lower interest rates than credit cards, which means you save money with this relief program.

Another way to save on interest rates is by applying for a balance transfer card with a 0% introductory APR. In addition to paying off your debts interest-free, your balance transfer fees may be waived. However, you should pay off your card before the promotion ends (usually within one to two years). Otherwise, you'll have to start paying interest rates on your remaining balance, with rates similar to a credit card. 

Before applying for personal loans, keep in mind that lenders may require a decent credit score to qualify for a debt consolidation loan with favorable rates. Additionally, some debt consolidation loans require collateral, says Natalia Brown, Chief Client Operations Officer at National Debt Relief. Brown explains that additional costs, such as prepayment and origination fees, can increase the cost of your loan.

What does debt settlement mean?

Debt settlement reduces the amount you owe. This debt relief program requires negotiating with your creditors to a settled amount for a single lump sum payment upfront.

Alternatively, you can work with a debt settlement company that negotiates on your behalf, increasing your odds of your creditors forgiving a portion of your debt. These companies require that you stop paying your creditors and deposit that money in a savings account instead. Once the debt settlement company determines you have enough money in that account, it will go to your creditors and begin negotiations.

Companies use repayment as leverage to persuade creditors to a settled amount. After all, debtors and creditors would rather collect some of your payment instead of none.

Debt settlement is an industry plagued by scams, but you can read Business Insider's list of the best debt settlement companies.

How a debt settlement program works

While this type of debt forgiveness program can be enticing, as you no longer have to pay a large portion of your debt back, it's usually not the best option. You should only consider debt settlement for extreme cases, often before filing for bankruptcy.

A debt settlement program can spell major repercussions on your credit scores since you're withholding payments from your creditors, which can put you in serious delinquency. When you settle debt, that negative mark will stay on your credit report for up to seven years. As the debt ages, its effect on your credit score will abate. 

Also, if you work with a debt settlement agency, you may have to pay a hefty fee for the service, usually 15% to 25% of the amount of your enrolled debt. Additionally, the IRS considers your forgiven debt taxable income, so you still have to pay taxes on the settled amount.

How to choose between debt consolidation and debt settlement 

Deciding between debt consolidation versus debt settlement comes down to your credit score, the type of debt you have, and your options. With debt consolidation, you must pay your entire debt, though your terms will be better. Meanwhile, debt settlement means you won't have to repay a portion of your debt.

When debt consolidation makes sense

With debt consolidation, you must pay your entire debt. However, this program provides debt relief by reducing your interest rates. You might choose debt consolidation if:

• You have multiple high-interest debts: By consolidating your debt, you can roll your debt payments into a loan with a better interest rate. If your debt is primarily comprised of credit card debt, you should apply for a balance transfer credit card with a 0% APR. Ideally, you'll pay off most, if not all, of your debts within that introductory period.
• You'd like to make your debts manageable: This debt relief program streamlines your debt payments into one payment per month instead of several monthly payments.
• You have a decent credit score: If you have a good credit score, you have a better shot at getting the best rates. "Debt consolidation may not be the best option if an individual only has a small amount of debt or if an individual has a poor credit history because they may not qualify for a low-interest consolidation loan," Brown says.

When debt settlement makes sense

Debt settlement should be used as the last resort before you declare bankruptcy. It may be worth it if you're out of other options. You might choose debt settlement if:

• You're settling debt on a single account: Settling your debt on a single account may hurt your credit score, but not as much as settling debt on multiple accounts. 
• You have more than $10,000 in debt: Most debt settlement companies require you to have at least $10,000 in debt to access their services.
• You're on the verge of bankruptcy: Debt settlement can be your lifeline if bankruptcy is a likelihood for you. "Consumers should consider a debt settlement if they're facing bankruptcy, if their payments are severely past due, have been charged off by your creditor, or are facing a lawsuit," says Bruce McClary, ​​​​​​​senior vice president of the National Foundation for Credit Counseling. While debt settlements can hurt your credit score, that decrease will still be smaller than the effect a bankruptcy has on your credit.

"If you are in the earlier stages of delinquency with your credit cards and unsecured debt, nonprofit credit counseling may be a more suitable choice before turning to debt settlement," McClary says. Many nonprofit credit counselors offer free consultations to help you discover debt relief options for your situation. 

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