Why Debt Consolidation Can Be a Better Choice Than Settling Debt

Deciding between debt settlement and debt consolidation? Read this first.

Owing money can be very stressful. If you find yourself with a large outstanding loan balance, chances are good that you'll be eager to repay it as soon as possible. However, it can be tough to manage and figure out how. There are a few approaches you can take, but two common techniques are debt consolidation and debt settlement.

To help you decide between the two, here's what you need to know about how each one works -- and why, for many people, debt consolidation is a better choice.

How does debt consolidation work?

Debt consolidation involves using a new loan to repay multiple existing debts. For example, you could take out a personal loan and pay off three credit cards and some medical loans with it. Or you could use a credit card balance transfer and move the outstanding amount charged on several cards onto one new balance transfer card.

Debt consolidation typically doesn't just combine your debts -- it gives you a new loan that has more favorable terms. For example, you could find a personal loan at a lower interest rate than your current creditors are charging and use it to consolidate your debts. And that would lower the financing charges and make repayment easier and cheaper.

How does debt settlement work?

Debt settlement isn't like consolidation. You don't get a new loan. Instead, you enter into an agreement with the creditors you already owe money to. Typically, they agree to accept a smaller amount than you currently owe, thus settling your debt for less than the full outstanding balance.

Debt settlement could involve making a lump sum payment or entering into a repayment plan. Often, debt settlement companies offer to negotiate a settlement for you with your creditors but you can also do this on your own by working with your creditors directly. This allows you to save the fees that specialized debt settlement companies charge.

Why is debt consolidation a better choice?

Debt consolidation is generally preferable to settlement for a few key reasons.

1. Consolidation won't damage your credit, but debt settlement will

Most often, creditors won't agree to settle your debt until you've been late on payments. And they will report your debt as settled, rather than paid in full. Both can hurt your credit score.

Consolidation doesn't damage your score like this, and it can improve it long term if you show you can pay back your consolidation loan on time.

2. You don't need creditor permission for consolidation

You can only settle debt if your creditors agree. But as long as you can get approved for a consolidation loan, you don't need permission from your current creditors to do it.

3. You're sometimes taxed on settled debt

Getting taxed on a settled debt can impact your IRS bill. And in some cases, that could push you into a higher tax bracket, which would mean you'd end up owing a good amount of money. Depending on how that math breaks down, it might not be worth it to settle a debt if you can consolidate instead.

Think carefully about what's best for your situation when deciding how to pay off debt. But, often you'll find consolidation is the right option for these three important reasons.