Debt Settlement vs. Debt Consolidation: What is the Difference?

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Do you know the difference between consolidating debt and settling your debt? While both processes help you deal with owing money, they are definitely not the same.Image source: Getty Images.

Have you found yourself with lots of monthly bills for high interest debts? If so, keeping track of all the payments you need to make may be a hassle -- and you may even be unable to make all of those payments without running short of cash for basic living expenses.

If you're struggling with the debt you owe, you may be looking into different options to get your financial burden under control. You'll probably come across two possible options for dealing with debt when you try to find a way to solve your problem: debt settlement and debt consolidation.

While debt consolidation and debt settlement may sound similar, there are major differences between the two processes. You need to understand both options -- and the implications of each choice -- before you decide if either is right for you.

What is debt consolidation?

Debt consolidation involves borrowing money to repay existing debt. You take out a new loan, and you use the money from that new loan to repay existing creditors.

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You can consolidate debt by taking out many different kinds of new loans. For example, you could take a personal loan and use the proceeds to consolidate debt. You could take a home equity loan and borrow against the equity in your house to repay your existing debts. Or, you could apply for a balance transfer credit card and transfer existing debts to the new card so you've changed who you owe.

There are pros and cons to each of these different approaches to debt consolidation, but what they all have in common is that your new loan has different repayment terms than the existing debts.

Typically, when people consolidate debt, they do so in order to reduce the interest rate they pay. If you take a balance transfer, for example, you may be able to get a 0% promotional rate -- so you could reduce your interest rate to 0%. Personal loans and home equity loans also typically have lower interest rates than most high interest consumer debt, such as credit cards.

Consolidating debt also allows you to have one payment -- for your new loan -- instead of multiple payments to existing creditors. This simplifies the repayment process and makes it much easier to pay back what you owe.

Since your interest rate is lower, your new monthly payment may also be lower -- depending upon the term of debt repayment. The longer the timeline to repay your new loan, the more total interest you'll pay over time, but the lower your payment will be.

Debt consolidation doesn't hurt your credit

Another thing every consolidation loan has in common: you repay your existing debt in full. You don't reduce the total principal balance you need to pay off. While you may end up reducing the total amount you pay back since you'll pay less in interest, you still pay creditors the full amount you borrowed.

Because you're repaying all that you borrowed, debt consolidation doesn't damage your credit. You may see a short-term decline in your credit score because an inquiry goes on your credit report when you apply for the new loan, and a short-term decline if you max out a new credit card with your transferred balance.

But, as you pay the consolidation loan and develop a positive payment history, your credit might actually improve. This is especially true if you've taken out a personal loan or home equity loan and now have a broader mix of different kinds of credit on your credit report.

What is debt settlement?

Debt settlement is very different from consolidation. It does not involve taking out a new loan to repay what you owe. Instead, it involves talking with existing creditors and working out a deal to pay back less than you owe on your debt.

Creditors are typically not willing to talk with you about debt settlement when you're current on your bills and making at least minimum payments. However, if you fall behind or if creditors have reason to think you might default or declare bankruptcy, they may be willing to allow you to settle your debt for less than you owe because at least they'll get paid something.

When you arrange a debt settlement plan, you negotiate with the creditors about how much you'll have to repay and the terms of repayment. There are debt settlement companies and credit counseling services that will do this for you, but many are disreputable, charge high fees, and don't actually provide promised help. In most cases, you can successfully talk with creditors on your own as long as you have an idea of what you can pay and your proposed suggestion is reasonable.

When you negotiate a debt settlement plan, you may agree to pay a lump sum amount if the creditor will forgive the remaining balance. Or, you may go on a payment plan to pay a reduced amount, lowering your monthly payments and the total you owe.

Whatever you and your creditor agree to, make sure you get the plan in writing before you send in any payment and do not give the creditor your bank account information.

With debt settlement, you pay back less but hurt your credit

While every case is different, debt settlement can sometimes significantly reduce the total you have to pay back.

It is not uncommon for creditors to agree to a settlement that allows you to pay back just 30% to 70% of the outstanding balance if the creditor is very concerned that you won't be able to pay the bills. Being able to repay less than you borrowed can be a significant advantage if you're in over your head in debt.

However, the problem is that debt settlement can be very damaging to your creditor. You'll develop a history of late payments in the time leading up to the debt settlement -- otherwise creditors won't agree to negotiate with you. And, the debt will typically be reported as settled rather than paid in full, which damages your credit further.

Is debt settlement or debt consolidation right for you?

Debt consolidation can be a proactive step that helps you become debt free and build your credit. Consolidation using a balance transfer credit card or personal loan has minimal or no risk, although consolidating using a home equity loan is a high-risk choice because you put your home in jeopardy if you can't pay. If you have high interest debt and can qualify for a balance transfer or personal loan that drops your rate, there's little reason not to do it.

Debt settlement, on the other hand, can damage your credit for years to come. Debt settlement is still preferable to bankruptcy and, depending how deeply in debt you are, it may be worth taking the hit to your credit to climb out of a hole without having to spend years making payments that barely cover the interest much less reduce the principal.

Before you consider debt settlement, though, carefully consider whether you might be able to consolidate your debts into a new loan with better terms that you can more easily pay back. If you think consolidation may be an option, do this as soon as possible before you get a history of late payments and become ineligible for a new loan on more favorable terms.

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