What are the Differences Between Debt Consolidation and Debt Settlement?

Whatever your living situation, you have some sort of bill to pay. Whether it’s paying the bank for the mortgage you negotiated when you bought your home or paying off the school books you paid for on your credit card, your mailbox or inbox are full of payment notices. When you owe money, the best thing you can do for your credit score, and sanity, is to pay what you owe by the due date. But sometimes that is not possible.

The all-too-common circumstances of losing a job or the sudden increase in expenses for any number of personal circumstances can change your ability to pay your debts. If this has happened to you, you may have been presented with paths to relief, including debt consolidation and debt settlement.

Debt consolidation and debt settlement are both processes for paying off what you owe, but they tackle the problem from different angles. Debt settlement focuses on renegotiating the amount of money owed, while debt consolidation focuses on shifting who the money is owed to. Settlement shrinks the total amount you owe; consolidation combines all of your debts into one lump sum payment.

If you have overdue unsecured debt, which is a loan not tied to a house, car, or other asset, you can likely pursue settlement or consolidation.

The functional steps of each process are important to understand though because they can have ramifications for other parts of your financial well-being, like your credit score.

The traditional debt settlement process:

  1. Tell your creditors that you don’t have the funds to pay them everything you owe and that you’ll be stopping all payments to them
  2. Begin to set aside funds on a monthly basis to build up a lump sum of cash
  3. Go to your largest outstanding creditor and let them know that you’ve accumulated that lump sum and that if they forgive most of your outstanding debt, you’d be willing to partially repay them
  4. Negotiate over how much you will need to repay
  5. Document the settlement and pay the agreed upon amount back to the creditor
  6. Repeat steps two through five until all creditors have individually accepted your settlement offers

To consolidate your debt:

  1. Evaluate how much outstanding debt you have across all of your accounts (credit card accounts, personal loans, healthcare debt, etc.)
  2. Shop for a consolidation loan through one of many traditional or online lenders
  3. Attempt to find an APR (interest rate) that is as low as possible (this limits future interest you are responsible for)
  4. Select the lender of your choice and borrow the total amount of your other outstanding debts
  5. Use the consolidation loan funds to pay off all outstanding balances on your existing accounts
  6. Do everything you can to make your monthly payments on your new consolidated loan and rebuild your credit score

Note: Most consolidation loans require collateral such as a home, car, or retirement account to be seized in case the loan is not repaid in full in a timely manner. But you will have a lower interest rate than otherwise.

Balance transfer cards are another option that charge 0% interest for a certain time period - typically a year to a year and a half - which helps you pay back the balance owed on your own time.

If the amount you owe is larger than you could possibly ever pay back, settlement may be your best bet. But if you can currently start paying off a non-negotiable, lower-interest loan, consider consolidation.

After you decide which functional process is right for you, you should consider whether you will be able to go through that process on your own, or will require the help of a professional advisor. Advisors can be both for-profit companies or non-profit organizations. Regardless, they will coach you on how to effectively go through each process and remove some of the weight of managing the details yourself.

Always make sure to clearly understand their fees and review their Better Business Bureau profile before working with them. You’re asking, and paying, these companies to handle a big task that will affect your future, so be sure you trust the company and have sound background information on them.

Also be sure to consider the potential risks when refinancing your debt. Your credit score is likely already affected by your payment delinquency, and fixing your debts by settling or consolidating them will further hurt it in the near-term. While terms of your repayment are being discussed, you may be encouraged to stop paying collections agencies and others asking for their money altogether. This could build up late fees and interest on top of what you already owe. While debt consolidation lowers your interest payment each month, the length of time you pay that interest amount may mean you’re paying more in the long run. Make sure you truly understand your situation and weigh the potential long-term risks before you make a final decision.

Regardless of what option you choose, a conversation with your creditors is always the best first step. To facilitate this, Kredit provides it’s communications platform free of charge so you can easily manage all of your discussions in one place.

Things to consider if you’re self-negotiating:

  • The more delinquent your debt is, the higher the forgiveness rate you can negotiate
  • If you can show legitimate hardship, forgiveness will be more likely
  • If you can save money for a lump sum payment instead of multiple payments over time, you can also negotiate a higher forgiveness rate