The Pros And Cons Of Debt Consolidation Vs. Debt Settlement

18 Min Read
Updated Feb. 15, 2024
Written By
Dan Rafter
Young woman sitting at table with laptop open, using calculator and reviewing notebook.

Struggling with debt? Feel like your credit card’s balances are always rising, no matter how many dollars you devote to paying them down? Are messages from collection agencies clogging your voice mail? It might be time to turn to debt consolidation or debt settlement.

Both financial strategies can help you get your debt under control. But consolidation and settlement are not the same thing. If you consolidate your debt, you’re still responsible for paying it off over time. In debt settlement, the companies that you owe agree to eliminate at least some of your debt.

Which approach is right for you? This depends largely on the amount of debt you face and your ability to pay it off.

What Is A Debt Consolidation Loan?

Of these two options for dealing with debt, a debt consolidation loan is the more common solution.

In a debt consolidation loan, you take out a new loan with a lender and use the lump-sum payment from that loan to pay off your existing debt. You then pay back your new loan, with interest, in regular monthly payments.

The goal is to end up with one monthly payment that you can comfortably afford, hopefully at a lower interest rate than the ones attached to your existing debt. Make sure before taking out a debt consolidation loan that you can afford the payment each month. Missing payments on this loan could devastate your three-digit credit score.

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What Are The Best Ways To Consolidate Debt?

Interested in debt consolidation? You have several options.

Personal Loan

A personal loan is one of the more common ways to consolidate debt. You’ll work with a lender to take out one of these loans, and you’ll receive a lump-sum payment once that lender closes the loan.

You can then use this money to pay off your existing credit card bills and other debt. You still must pay off your new loan, with regular monthly payments. You’ll also have to pay interest on this loan. The goal, though, is that your new interest rate will be lower than the interest you’re paying on your existing debt, especially on your credit card balances.

Work with your lender to make sure that your personal loan’s monthly payment is one that you can afford. If that payment is too high, you’ll struggle again to pay off the new debt.

You’ll have to meet certain financial requirements to get a personal loan. Lenders will look at your credit score and monthly debts to make sure that you can afford your monthly payment and are likely to make your payments on time.

Home Equity Loan Or Home Equity Line Of Credit

If you own a home and you have equity in it, you can also consolidate your debt by taking out a  home equity loan or a home equity line of credit (HELOC)

Equity is the difference between what you owe on your mortgage and what your home is worth. If your home is worth $350,000 and you owe $250,000 on your mortgage, you have $100,000 of equity. You can then take out a home equity loan or line of credit for a percentage of that, with a lender maybe approving you for a loan of $80,000. You’d pay that loan back in regular monthly payments with interest.

Home equity loans and HELOCs work differently. With a home equity loan, you’ll receive a single payment that you pay back each month. You can use that payment for whatever you like, including consolidating high-interest-rate credit card debt to a lower-debt loan. Home equity loans are a good choice to consolidate debt because they typically come with lower interest rates. 

A HELOC works more like a credit card with your home’s equity as its credit limit. With a HELOC, you have more flexibility in how much you borrow at a time. If you have a HELOC of $80,000, you might borrow $30,000 to consolidate your credit card debt. You then only pay back what you borrow, with interest. Again, homeowners turn to HELOCs to pay off credit card debt because these loan types come with lower interest rates.

Cash-Out Refinance

Homeowners with equity can also turn to a cash-out refinance to consolidate debt. In a cash-out refinance, you swap your current mortgage loan with a new one. But you also borrow more than what you owe on your current mortgage, using the extra cash for whatever you’d like, including consolidating debt with higher interest rates.

Maybe you owe $200,000 on your mortgage. Instead of refinancing to a new loan for that amount, you refinance to a mortgage of $250,000. You can then use the extra $50,000 to pay off your existing debt.

Remember, though, that you must pay back the full amount that you have borrowed, with interest. If you refinance for more than what you owe on your current mortgage, you will have to pay back a higher amount.

Balance Transfer Card

Several credit cards offer new cardholders a 12- to 18-month period during which they can transfer debt from their other cards to their new card with no interest. This gives cardholders the chance to pay off existing debt that previously came with interest rates of 19%, 20%, 22% or more without paying any interest at all.

This makes balance transfer cards a good choice for paying off debt. But you must be diligent about devoting extra money to paying down the balance that you’ve transferred. These 0% balance transfer offers don’t last forever. If you don’t pay off your transferred debt before the introductory offer expires, the left-over amount will be assigned your new card’s standard interest rate, which could be 20% or higher.

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What Are The Pros And Cons Of Debt Consolidation?

As with any financial decision, there are positives and negatives that come with debt consolidation.

Pros Of Debt Consolidation

  • Money savings on interest paid: If you use a loan type with a lower interest rate, such as a personal loan, home equity loan or balance transfer, you can reduce the amount of interest you pay while tackling your debt. This is especially true if much of your debt is on credit cards. Credit card debt comes with some of the highest interest rates of any form of debt, often coming in at 24% or more. You might qualify for a home equity loan or personal loan with a rate that’s one-third to one-half that rate, depending on your credit.
  • Fixed payoff date: If you turn to home equity loans, HELOCs, a cash-out refinance or personal loan to pay off your debt, you’ll know exactly when that debt will disappear. That’s because lenders will provide you with a pay-off schedule that lists your monthly payments, how much interest you’re paying and your loan’s pay-off date. This gives you a tangible goal to work toward.
  • Fewer monthly payments: By consolidating your debt into one loan, you’ll reduce your number of monthly payments to just one. That’s easier to track than juggling five or more monthly credit card and other debt payments.
  • Improved credit score: Taking out a debt consolidation loan will immediately cause at least a small hit to your three-digit credit score. That’s because you’re taking on a new loan, something that will cause your score to drop slightly. But this is only temporary. If you make your payments on time each month, you’ll steadily rebuild, then increase your credit score. That’s because on-time payments are the biggest factor in calculating your credit score. And as you reduce your monthly debt? That will boost your credit score, too.

Cons Of Debt Consolidation

  • You’ll need good credit to qualify: You’ll need at least an average credit score to qualify for a personal loan or home equity loan with an interest rate low enough to make debt consolidation worthwhile. You won’t need a perfect score, but most lenders will require a minimum credit score in the low- to-mid-600s to qualify for such loans. Your score might be lower if your high amount of debt has caused you to make late payments in the past.
  • Upfront costs: Lenders often charge upfront fees to originate personal loans, home equity loans, HELOCs or cash-out refinances. You might be able to roll these fees into your monthly payments but be aware that debt consolidation is typically not free. Most refinances, for instance, cost from 2% to 6% of your loan amount. If you owe $200,000, that comes out to $2,000 to $12,000, which you would usually roll into the amount you’re borrowing.
  • Larger single payment: Taking out a debt consolidation loan might also leave you with a larger single monthly payment instead of several smaller ones. While that’s easier to keep track of, it might also be more difficult for you to pay, depending on how your income flows into your bank account each month. Maybe a portion of your income doesn’t hit your bank account before your larger monthly payment is due. It might be more of a struggle to make that payment on time each month.

What Is Debt Settlement?

If you’re struggling with your debt, you can also turn to debt settlement services. With this approach, either you or a company that you hire negotiates with the creditors to whom you owe money. The goal of these negotiations is to lower the amount of debt you owe or to eliminate it completely.

Say you owe $20,000 to three credit card providers. In debt settlement, you’d either call these providers yourself or work with a private debt settlement agency that would contact them for you. If you can show that you can’t pay all your debt but that you can repay some of it, your credit card providers might agree to lop off some of what you owe. Maybe instead of having to pay back $20,000, you’d only be required to repay $10,000.

The challenge is convincing your creditors to forgive some or all your debt. The companies to which you owe money are under no obligation to forgive any of what you owe. Your best chance might be to convince these creditors that by forgiving a portion of your debt they will at least receive some of what you owe.

What Are Some Debt Settlement Methods?

Consumers have three main options when pursuing debt settlement.

Doing It Yourself

The most affordable approach to debt settlement? Do it yourself.

To start this process, call the providers you owe. Maybe you owe thousands of dollars on a credit card. Call that card’s provider and explain that you’d like to repay some of your debt but can’t afford to repay it all. Ask if the provider is willing to eliminate some of what you owe and create a repayment schedule that works with your budget to cover the rest of your debt.

Your creditors are not obligated to accept your offer. They might be more likely to erase part of your debt if you have already racked up several late payments. Providers might look at these missed payments and decide that receiving at least some money from you is better than receiving nothing.

Even if your creditors are not willing to eliminate any of your debt, they might agree to lower your interest rate or give you more time to repay without charging late penalties. Again, though, creditors aren’t required to do any of this. They might instead insist that you pay what you owe in full and on time.

Choosing For-Profit Debt Settlement

Don’t want to go the DIY route? You can also hire a private debt settlement company. These companies will negotiate on your behalf with your creditors, though they’ll only do it for a fee. That’s part of the risk of working with debt settlement firms. They might charge high rates for their services, and there’s still no guarantee that they’ll be able to persuade your creditors to erase all or part of your debt.

If you work with a private debt settlement company, it might request that you deposit money in an escrow account to save for future repayments. The company might also recommend that you stop paying your creditors. The theory is that these missed payments will encourage creditors to agree to a settlement because they would rather receive at least some payment from you.

This can be extremely risky. Even if you stop making your payments, your creditors might not agree to eliminate all or any of your debt. And by not making your payments, you are only causing additional damage to your credit score and building up the money that you owe. You might also force your creditors to send your accounts to collection agencies. This will cause additional damage to your credit score. It will also open you up to phone calls and texts from these collection agencies.

Be careful when choosing a debt settlement company. Some of the individuals or companies advertising their services in this industry are scammers happy to take your money while providing little or no results. To increase the odds of hiring a legitimate provider, only work with companies approved by the American Fair Credit Council (AFCC).

Using A Nonprofit Debt Management Company

You can also work with a nonprofit credit counseling service. These services work with consumers to help them manage their debt and develop repayment plans that they can afford.

With this approach to debt management, you might make a single payment to the credit counseling organization each month. The organization would then use this money to pay your creditors. This ensures that you won’t miss any of these payments.

Credit counselors rarely negotiate with your creditors to erase any of your existing debt. But they might work with your creditors to reduce your monthly payments. They might convince the companies you owe to increase the length of your loans, something that would lower your monthly payment. They might persuade credit card providers to lower your interest rate, another move that would reduce your monthly payment. 

If you’re interested in working with a nonprofit credit counselor, search for companies approved by the National Foundation for Credit Counseling (NFCC) or Financial Counseling Association of America (FCAA).

What Are The Pros And Cons Of Debt Settlement?

Whether you choose to work on your own or with the help of a private company, debt settlement comes with its own pros and cons.

Pros Of Debt Settlement 

  • Owing less money: If your debt settlement efforts are successful, your creditors will eliminate at least some of the money you owe. This can reduce your financial burden.
  • Getting out of debt faster: If your creditors reduce your debt, you’ll pay back what you owe faster. This will lower the amount of interest you pay on your debt, something that could save you thousands of dollars depending on how much you owe and how high your interest rates are.
  • You might avoid calls from debt collectors: If your creditors are working with you to settle your debt, they might be less likely to send your accounts to debt collectors. This eliminates the stressful calls or texts from these companies.
  • You might avoid bankruptcy: If your debts become unmanageable, you might have to file for bankruptcy protection, something that will devastate your credit. If you settle at least some of your debt, you might be able to avoid this drastic financial step.

Cons Of Debt Settlement

  • Loss of access to credit: If you agree to a debt settlement agreement with the provider of your credit card, you probably won’t be able to use that card again.
  • Less control over finances: If you work with a private debt settlement company, that provider will gain at least some control over your finances, dictating when you pay your creditors, how much you pay them and whether you deposit some of your dollars into an escrow fund dedicated to paying off your settled debt.
  • Added costs: Debt settlement typically isn’t free, especially when you work with a private firm. Be sure to include your provider’s costs when determining how much you’ll need to pay to eliminate your debts.
  • A potential drop in your credit score: If a lender closes your account after settlement, it will lower your credit score. Your credit score will also fall if you stop making payments to your providers before you close a debt settlement deal.
  • Owing taxes on forgiven debt: You might face a tax hit if you settle your debt. The IRS says that when debt is canceled or forgiven for less than what you owe, you must report the canceled debt on your tax return. You’d then have to pay taxes on this amount because the IRS considers it to be income.

Which Is Right For You? Debt Settlement Vs. Debt Consolidation

Debt settlement might be the better choice if you have a lower credit score and can’t afford your monthly payments. By working with your creditors to settle at least a portion of your debt, you might be able to avoid bankruptcy. You also might keep your accounts away from debt collection agencies.

If you have a stronger credit score, applying for a debt consolidation loan might be the smarter choice. Most lenders that originate home equity or personal loans require that borrowers have a credit score of at least 640, though this does vary. Be sure that your budget can handle whatever new monthly payment you must make to repay your debt consolidation loan.

Debt Consolidation

Debt Settlement

Credit needed to qualify

You’ll typically need a credit score in the mid-600s to quality for debt consolidation.

This is usually reserved for consumers whose credit scores are too low to qualify for debt consolidation options such as personal loans or home equity loans.

Reduction in the amount owed

Debt consolidation doesn’t reduce what you owe. But you might qualify for a lower monthly payment or interest rate.

Your creditors might forgive at least a portion of your debt, reducing the amount that you owe.

Effect on credit score

If you make the payments on your debt consolidation loan on time each month, you’ll steadily improve your credit score.

Your credit score will take a dip if your lender closes your account after debt settlement. Your score will fall, too, if you deliberately miss payments before negotiating a debt settlement.

Potential costs 

Lenders will often charge you closing fees when originating a loan. This varies, but when refinancing, closing costs can run from 2% to 6% of your total loan amount.

Private debt settlement companies don’t work for free. You might have to pay a fee of up to 20% of your total debt.

Debt Consolidation Vs. Debt Settlement: FAQs

Questions about debt consolidation and settlement are common. Here are answers to some of the most common ones.

Is debt consolidation the same as debt settlement?

Debt consolidation and debt settlement are not the same. With debt consolidation, you’ll take out a loan – it could be a personal loan, home equity loan, HELOC or cash-out refinance – and use the funds from this loan to pay off your other debts. This will leave you with one payment that hopefully comes with a lower interest rate. In debt settlement, you negotiate, either on your own or with a private company, a reduction in the amount you owe. Your goal is to convince your lenders or creditors to forgive at least some of your debt.

Can I consolidate debt with bad credit?

It is possible to qualify for debt consolidation with bad credit. But if your credit score is too low, you may not quality for an interest rate low enough on your new loan to make debt consolidation worthwhile.

How can I find reputable debt settlement companies?

Some companies that advertise debt settlement services will take your money and then do little or nothing to reduce your debt. To boost your odds of finding a reputable debt settlement company, look for firms approved by the AFCC or contact the office of your state’s attorney general for information about any debt settlement service you’re considering.

Is debt settlement better than bankruptcy?

Bankruptcy can seriously damage your credit score. Depending on the type, a bankruptcy filing will also remain on your credit reports for 7 to 10 years. That doesn’t mean, though, that debt settlement is always a better solution. Filing for bankruptcy might help you gain control over your finances. If you’re considering bankruptcy, speak with a credit counselor or bankruptcy attorney first.

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The Bottom Line: Find The Best Debt Reduction Option For You

Determining whether debt settlement or consolidation is right for you is no easy task. You’ll need to take a close look at your financial situation to determine if either solution is the right choice. It is recommended that you speak to an experienced financial advisor who can offer advice based on your specific situation and financial goals.

If you do decide on debt consolidation, a personal loan can help you get the money you need to pay off high-interest-rate debt through debt consolidation. If you have a significant amount of equity in your home, a cash-out refinance or home equity loan may be a good option. You can today to see what rates and terms might be available.


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