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If you’re having trouble managing your debt, you may be considering debt consolidation or debt settlement. Debt consolidation and debt settlement are two forms of debt relief that can help you manage your debt, but they have very different functions. In general, debt consolidation reduces the number of creditors you owe, while debt settlement reduces the total debt you owe.
Each option has its challenges and drawbacks – not everyone is in the right position to consolidate or settle debt. Depending on your overall finances, credit score, amount of debt, and other factors, debt consolidation or debt settlement may or may not help you.
Here, we explore debt consolidation, debt settlement, and how to decide which approach, if any, is best for your financial situation.
Debt consolidation is a form of debt relief that combines multiple debts into one new consolidated debt. Instead of owing money to multiple creditors and having multiple monthly payments, debt consolidation allows you to reorganize those debts into one combined total. 0% balance transfer credit cards and debt consolidation loans, or personal loans, from a bank or credit union are among the most common ways to consolidate debt.
Typically, with debt consolidation, your old debt is paid off with the new loan. For example, if you currently owe a total of $15,000 on three different credit cards, you could get a $15,000 personal loan and then pay off those three credit card balances with the funds from your new loan. You will still owe $15,000, but the debt will be in the same place with one monthly payment and possibly at a lower interest rate. When a debt consolidation loan comes with a lower interest rate, you can pay off debt sooner and with a lower total cost.
It is important to remember that you will still owe the same amount of principal balance if you choose debt consolidation. And, if you decide to continue borrowing money on top of your consolidated debt, you could run into financial difficulties.
Debt consolidation can provide more visibility and control over your debt. Combining all your debts into one might give you more determination to pay off the debt once and for all.
When debt consolidation makes sense
Debt consolidation may be the right choice in a few different circumstances:
- You want to simplify your debts. Instead of multiple debts and multiple monthly payments, you can consolidate your debts into one. If you find it difficult to make many monthly payments, debt consolidation could help reduce your financial stress.
- You can get a lower interest rate. Debt consolidation can be a good choice if you can get a lower interest rate on consolidated debt. For example, if you can combine multiple high-interest credit card balances on a limited-time 0% APR balance transfer credit card, it can help you pay off your debt faster.
- You are ready to make a plan to pay off your debts. Even if you are not experiencing financial stress, debt consolidation can help you control your debt or pay it off completely. If you want to focus on paying off your debts, debt consolidation can help you lower your interest rate, get better organized to pay off your debts, and improve your financial situation.
Alternatives to debt consolidation
Debt consolidation is something you manage yourself. But you might need another level of help. An alternative is a debt management plan from a consumer credit counseling service
If you are having financial difficulties, consumer credit counseling services can help you pay off your debts by developing a repayment plan for you. If you sign up for this type of program, the consumer credit counseling service will work with your creditors and try to lower your interest rate and fees.
With a debt management plan, you typically make a monthly payment to the consumer credit counseling agency, which then forwards the payment to your creditors. They don’t renegotiate the total amount of debt, but they help you develop a plan to pay off your debt, while potentially helping to reduce fees and costs.
Debt settlement is another form of debt relief that is sometimes compared to debt consolidation, but it is quite different. Unlike debt consolidation, where you end up paying off your entire debt balance, debt settlement is a form of debt forgiveness in which your creditors agree to let you pay a lesser amount of what you owe.
Debt settlement can be risky and is generally considered an option of last resort. If you’ve exhausted all other options, debt settlement may seem like the way to go. Even then, many experts advise exploring other options.
Indeed, it is important to be aware of the risks. Debt settlement usually involves being past due on your bills and then settling with creditors a smaller percentage of what is owed. This can damage your credit score and appear on your credit reports for up to seven years. There is no guarantee that your creditors will agree to settle your debts – they may choose to sue you for repayment instead. If you are successful in getting debt forgiveness, the forgiven amounts may become taxable income that is reported to the IRS, causing you to pay taxes on the forgiven amount.
Debt settlement is an option that you can manage on your own if you are comfortable speaking with your creditors and asking for an agreement on your debts.
There are also debt settlement companies that will offer to negotiate with your creditors for you in return for a commission, which is often 15-25% of the total debt listed. As part of the debt settlement process, these companies will ask you to make payments to a separate account that they have set up for you. This money is then used to repay the amount of your settled debt after negotiations with creditors.
When Debt Settlement Makes Sense
Debt settlement can be risky and complex. There is often a better alternative, but if you feel you have exhausted all other options, here is when debt settlement may be an option:
- You have no more options. If you have less than perfect credit, don’t want to apply for a loan anymore, and can’t qualify for a low-interest debt consolidation loan or balance transfer credit card, you might consider settling your debts.
- You don’t want to declare bankruptcy. If you are unable to file for bankruptcy or have debts that cannot be discharged in bankruptcy, debt settlement may be an option.
- You are ready to take a hit on your credit report. If your debts have become so unmanageable and stressful that you are willing to risk damaging your credit report through default, you can pursue debt settlement.
Debt Settlement Alternatives
Instead of hiring a debt settlement company, you will often get a better deal for your overall financial situation by working with a consumer credit counseling agency. Instead of being overdue with your debts and potentially hurting your credit score, consumer credit counseling can help you stay on top of your bills and pay off your debts without the potential risks and consequences. longer term debt settlement.
Debt Consolidation vs Debt Settlement
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Frequently Asked Questions (FAQ)
How does debt consolidation work?
Debt consolidation works by combining your existing debt into new debt, ideally at a lower interest rate. For example, let’s say you owe $2,500 on one credit card, $5,000 on another card, and $7,500 on other debts. You could get a $15,000 debt consolidation loan. Once you have paid off your pre-existing debts with your new debt consolidation loan, you make one payment on your new loan each month.
What is a consumer credit counseling service?
Consumer credit counseling organizations are generally non-profit organizations offering certified and trained counselors. These counselors can help you manage your money and debt, create a budget, and educate you on financial matters.
Some credit counseling organizations will help you create and implement a debt management plan. With this type of plan, you always pay the full principal amount you owe. You make a one-time payment to the organization each month and the organization makes a payment to your creditors.
Can I negotiate a debt settlement myself?
The first step in the debt settlement negotiation process is to dig into your debts to assess how much you owe and whether it is possible to pay without a settlement agreement. Once you’ve done your homework and put some money aside, you can start figuring out your settlement offer. Creditors may agree to accept 40% to 50% of what you owe.
It is important to remember that most creditors will not negotiate or settle a debt unless you are late paying. And keep in mind that the debt settlement process can take two to four years, depending on the overall amount of your debt and the complexity of your situation.
How does debt settlement affect my credit rating?
Debt settlement can hurt your credit score because the process forces you to stop paying your bills and not pay your debts. In addition to the blow to your credit, some creditors may refuse to negotiate with you and could sue you for nonpayment and garnish your wages. For these and other reasons, debt settlement can be risky and is not an ideal option.