Debt Consolidation vs. Debt Settlement: Which Is Best for You?

Both debt consolidation and debt settlement are tactics to pay down your debt, but they work in very different ways. While debt consolidation involves using a personal loan or credit card to pay off multiple debts with a single new loan, debt settlement involves negotiating down your debt. 

Both have pros and cons, but debt consolidation is far less risky than debt settlement, which can result in severe credit damage. Below, learn how each strategy works, its pros and cons, and how to decide if one is right for you.

What is debt consolidation?

Debt consolidation involves paying off multiple debts with a new loan or line of credit. By consolidating debt, you combine all of your monthly debt payments into a single — and ideally lower — monthly payment. 

This strategy has a few key advantages. 

1. Fewer accounts: Consolidating your debt minimizes the number of accounts you need to keep track of, which can make it easier to stay on top of payments. 
2. Less interest: If you qualify for a debt consolidation loan with a lower interest rate than your current debts, you could save money on interest. 
3. Lower monthly payment: Even if you don’t qualify for a lower interest rate, you could lower your monthly payment with an extended repayment term.

Unlike debt settlement, debt consolidation doesn’t change the amount of debt you owe — it simply restructures it. 

Types of debt consolidation

There are several ways to consolidate your debt, each with pros and cons.

Personal loan

Best for borrowers with fair credit or better

The term “debt consolidation loan” typically refers to a personal loan. Personal loans are a type of installment loan. Interest rates are fixed (meaning they won’t change over the life of the loan, as variable credit card rates do) and you receive your loan funds upfront. You then repay the principal and interest in equal monthly payments that are also fixed for the repayment period, which often ranges between two and seven years. 

Personal loans tend to have lower interest rates than credit cards, making them a good choice for debt consolidation. However, you’ll need at least fair credit to qualify for a personal loan with most lenders, making it a less viable option if you have bad credit. Plus, some lenders charge personal loan origination fees upfront, which can cut into your loan proceeds.

Balance transfer credit card

Best for borrowers with good credit

A balance transfer credit card allows you to transfer debt to a single credit card, which typically comes with a low- or no-interest introductory period. Often, this period lasts around 15 to 18 months before adjusting to the card's regular rate. If you can pay off the balance before the introductory period ends, a balance transfer card can save you a lot in interest.

However, most balance transfer cards charge a balance transfer fee between 3% and 5% of the amount being transferred. Plus, you’ll typically need at least good credit to qualify for a new card with a 0% APR balance transfer offer.

Home equity loan or HELOC

Best for borrowers with home equity and good credit

A home equity loan is a type of installment loan that provides money upfront based on the equity in your home. Rates are typically fixed, and you make payments each month. Home equity lines of credit (HELOCs), on the other hand, typically have variable interest rates and offer a revolving line of credit (also based on your home’s equity) that you can access during a draw period, while making interest-only payments. 

Both home equity loans and HELOCs are secured by your home, so they tend to have lower interest rates compared to credit cards and personal loans. However, if you default on your loan, the lender could foreclose on your house.

Pros and cons of debt consolidation

Pro #1: Save on interest

One potential advantage of consolidating your debt is lowering your interest rate, which can reduce the total cost of your loans, speed up debt repayment, and lower your monthly payment. 

Pro #2: Lower your monthly payment

But even if you can’t qualify for a lower rate, you could still lower your payment. Both personal loans and home equity loans offer multi-year repayment periods. If you’re struggling to make payments now, a long repayment period could make them affordable and help you repair damage to your credit. In turn, you might qualify to refinance your debt consolidation loan at a lower rate later.  

Pro #3: Simplify repayment

Simplifying your finances is another benefit of debt consolidation. By combining your debts into a single loan with a single monthly payment, your progress and payments become easier to track.

Con #1: Fees

On the other hand, many loans have fees, such as balance transfer fees or loan origination fees, that can weigh against potential savings. Plus, the worse your credit history, the more likely you are to be charged some fees, like origination fees.

Con #2: High rates for fair credit

If you can qualify with fair credit, you may not get a rate lower than the rates on your current debt.

Con #3: Doesn’t address underlying issues

And while consolidating your debt can help you pay it off, it doesn’t address what got you into debt in the first place. Make sure you’ll be able to pay off a debt consolidation loan before taking one out. If not, you could compound debt problems and delay their resolution.

What is debt settlement?

Debt settlement is an agreement negotiated with your creditors in which you settle your debts by making a lump sum payment of less than what you owe. Often, a debt settlement company negotiates on your behalf. They may have you set aside money in a specific settlement account each month, and in the meantime, often advise you to stop making monthly payments.

Types of debt settlement

Generally, there are two types of debt settlement: a DIY approach and professional debt settlement.

DIY debt settlement

With DIY debt settlement, you handle the negotiations with your creditors. It involves creating your own settlement fund, presenting your case to your creditors, and keeping a record of any agreement you reach. 

Professional debt settlement

Professional debt settlement involves working with a for-profit debt settlement company that negotiates on your behalf. This approach can be risky,  as some debt settlement companies charge expensive fees without guaranteeing success and require that you stop making payments as a negotiation tactic. 

Pros and cons of debt settlement

Debt settlement is risky, but there may be benefits in specific situations. 

Pro #1: Could settle for less than you owe

If you reach a settlement, you typically pay off your debt for less than your original balance. 

Pro #2: Could pay off debt faster

Because debt settlement involves repaying your debt in a single lump sum, it’s possible you’ll pay off your debt in less time.

Pro #3: 

A debt settlement could help you avoid bankruptcy. That said, it does almost as much credit damage as bankruptcy and could potentially result in more psychological harm due to creditor and collection calls.

However, the disadvantages of debt settlement often outweigh the benefits. Mae Koppes, Certified Personal Finance Counselor and content director at Upsolve, says that debt settlement is rarely the best option. 

Con #1: Your credit could suffer

Most debt settlement companies require that you stop making payments so they’re in a better position to negotiate a settlement with your creditors. That means your credit will suffer from multiple late payments. But the credit damage doesn’t stop there. Once you settle debt, the account is noted as derogatory on your credit report, and can impact your credit score for seven years from the date of the first missed payment that led to the settlement.

Con #2: Could end up with more debt

As a result of stopping payments, you could be assessed late fees plus mounting interest on growing debt balances. If a settlement can't be negotiated, you could end up with credit damage plus additional debt.

Con #3: Expensive fees and holding funds

Debt settlement isn’t cheap. For example, National Debt Relief charges up to 25% of the amount of the debt enrolled once a settlement is reached. You may also be required to divert payments you would have sent to creditors to an escrow account held with the debt settlement company. These funds are ultimately used to settle your debts (if settlement is successful). However, being enrolled in a debt settlement plan isn’t likely to stop creditors or collectors from seeking payment. 

Con #4: Savings might be taxed

Any amount that is forgiven or charged off is considered taxable by the IRS, meaning you’d need to report it on your tax return. The creditor who forgave or settled the debt is likely to report it to the IRS as well.

Con #5: Could take years

The debt settlement process itself could take up to four years or longer if debts are successfully settled. 

Debt consolidation vs. debt settlement: key differences 

Though debt consolidation and debt settlement aim to relieve you of your debt, they aren’t the same thing. Here are some of the ways these two strategies differ.

• Process: Debt consolidation involves combining your debt into a single account without changing your balance. Settlement attempts to close your accounts by paying less than you owe.
• Cost: Debt consolidation may involve loan origination fees or balance transfer fees. Debt settlement through a debt settlement company may cost up to 25% of the amount you’re trying to settle, and your debt will accrue interest and late fees if you stop making payments.
• Long-term impacts: Debt consolidation can have a temporary and minor negative effect on your credit when you submit a loan application. But if you make consistent on-time payments on your new loan, your score will likely improve. Debt settlement can have extreme negative effects on your credit as a result of not making debt payments during settlement negotiations. 
• Eligibility: There aren’t any eligibility requirements to attempt debt settlement, but you generally need at least fair credit to qualify for a debt consolidation loan.

Tips on choosing the best option for you

In many cases, debt consolidation is less risky than debt settlement. If you have the credit to qualify for a loan and can afford to make your new monthly payment, debt consolidation may be your best option. 

On the other hand, if you’re in a desperate situation and your credit is already damaged, consolidation may not be possible or advantageous. If you can’t qualify for a new loan or afford your monthly payments, debt settlement might make sense. If you do go this route, however, be careful when choosing a debt settlement company. 

“Like almost anything else you buy, beware of wild promises and illogical claims,” suggests Howard Dvorkin, chairman at Debt.com. “No, you can’t wipe out all your debt in a day. Only consult debt settlement companies that offer a free debt consultation. Never pay anything up front. Also, do your own background check: How long has the company been around? The longer, the better.”

Other ways to get out of debt

Debt consolidation and debt settlement aren’t the only ways to get out of debt. If neither option works for you, consider these alternatives:

Create a debt payoff plan

If you can tighten your budget, you may be able to pay off your debt with a debt payoff plan, such as the debt snowball or debt avalanche method. 

• Debt snowball method: Focus on paying off your debts in order of the smallest balance to the largest. This method has the benefit of quick wins, which can be motivating.
• Debt avalanche method: Pay off your debt in order of the highest interest rate to lowest. You stand to save the most money with this method, but it can take longer to pay down debt if your largest account also has your highest interest rate.

Work with a credit counselor

A not-for-profit credit counselor, such as one certified by the National Foundation for Credit Counseling, can enroll you in a debt management plan, in which they work with your creditors to develop a payment plan. The plan may involve lower interest rates or waived fees and is usually low-cost. With a debt management plan, the credit counselor manages repayment on your behalf, and you often have to close the accounts you’re paying off.

File for bankruptcy

Bankruptcy is a legal process that relieves you from paying certain debts. But this relief comes at a cost: Bankruptcy remains on your credit report for up to 10 years, depending on the type you file. There are two main types of bankruptcy. Chapter 13 lets you keep property like your home while participating in a repayment plan, usually for three to five years. After the successful completion of that plan, any remaining debt in the plan may be discharged. 

Chapter 7 is called a straight bankruptcy, in which all your non-exempt assets are liquidated to pay off your debt, with the remaining debt being discharged. Many people who file Chapter 7 only have assets that are exempt and so aren’t required to liquidate anything.

“Just like settlement and consolidation, bankruptcy isn’t the right fit for everyone. But it’s not a failure. It’s a legal, legitimate tool for rebuilding,” says Koppes.