Debt consolidation vs. debt settlement: What's the difference?
Updated October 16, 2024, 2:46 AM EDT
Debt can keep you up at night — especially when you owe multiple creditors. If you have credit card debt, medical bills and outstanding loans, staying on top of monthly payments can be overwhelming. If you’re interested in paying down debt by bundling it together — also known as debt consolidation — you may want to consider a personal loan.
In fact, one of the most common reasons borrowers take personal loans is to consolidate debt. It’s a solid option, but when exploring ways to pay down your balances, it’s easy to confuse debt consolidation and debt settlement.
Debt consolidation and debt settlement: What's the difference?
While these terms might sound similar, there are significant differences between debt consolidation and debt settlement that could impact your credit score. With that in mind, it’s important to read the fine print and understand the terms of each so you don’t end up in financial trouble.
Debt consolidation
When consolidating debt, you secure a loan from a bank, credit union, or online lender and use the funds you’ve borrowed to pay off as much of your outstanding debt as possible. Instead of making payments to various creditors, you’ll make one to your lender.
One of the main advantages of taking a personal loan for debt consolidation is possibly qualifying for a lower interest rate. For example, according to the Federal Reserve, the average personal loan interest rate is 9.65%, which is lower than the average credit card interest rate of 14.65%.
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If you're able to lower your interest rate, your payments may be smaller, leaving you with more money in your budget. Or, you can keep your payment amount the same and pay off your debt faster thanks to that lower rate.
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Debt settlement
While you can attempt it on your own, debt settlement typically involves hiring a third-party company that contacts your creditors and tries to negotiate a smaller, lump-sum payment on your behalf. These companies charge between 15 and 25% of the original amount owed once the debt is settled.
But before negotiation can occur, you must stop making payments for at least 90 days, which will damage your credit and FICO score. At the same time, late fees and interest continue mounting. You can expect to receive threatening letters and phone calls from creditors during this period.
Most debt settlement companies require that you transfer funds into an escrow account regularly until you’ve accumulated a sufficient settlement amount. An independent administrator oversees this account and will likely charge a fee for this service.
Though it’s possible that your debt could be reduced, there’s no guarantee that your creditors will accept a smaller, lump-sum payment. So you could end up owing far more than when you started as a result of interest and penalties. If your debt is settled, the Internal Revenue Service regards the amount that you’re forgiven as income and, therefore, taxable.
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What happens if I sign up for debt settlement instead of debt consolidation?
If you find that you’ve signed up for debt settlement rather than debt consolidation, cancel your contract with the debt settlement company in writing as soon as possible.
You are entitled to all funds held in escrow as well as any accrued interest. You can then contact your creditors and advise them that you’ve canceled the agreement and will be handling the debt yourself. You can also seek out non-profit credit counseling to help you manage your debt.
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How do I rebuild my credit?
If you’re applying for a loan with bad credit, you’ll likely get denied or be forced to accept a high-interest rate. Rebuilding your credit may sound daunting, but it can be done in a few steps:
- Pay your bills on time and don’t miss any payments.
- Check your credit report. The Consumer Financial Protection Bureau recommends checking your credit report at least once a year and reporting any inaccuracies that could negatively affect your score.
- Monitor your credit utilization ratio. Even if you have a high credit limit, it’s in your best interest to use below 30 percent of what’s available to you.
- Consider a secured credit card. This account requires a cash deposit, which acts as your credit limit.
If you’re ready to restructure your debt, a personal loan offers a path to debt consolidation without the potential pitfalls posed by debt settlement. Get started on your application today.