Drowning in debt isn’t fun. Luckily, you have options. Before you jump into a solution, you should know the consequences. Generally, you have 3 options – debt consolidation, debt settlement, and bankruptcy. We can all agree that bankruptcy is the lowest on the priority list. From there, you must decide between consolidating and settling your debt. We’ll discuss the differences below.
What is Debt Consolidation?
When you consolidate debt, you bring it together into one loan. You start by applying for one large loan. You use the proceeds of that loan to pay off the other debts. You still pay the same balance, the creditor doesn’t write your debt off. Instead, you restructure it by paying it off with proceeds from another loan. You only have one payment instead of several payments, though.
Debt consolidation should leave you with a lower average interest rate and lower payment. While it seems like you might save money, it’s not always the case. It depends on the method you choose. Here are a few examples:
- Balance transfer credit card – If you secure a 0% APR credit card, you might save money. The trick is to pay the debt off before the interest begins. If you don’t pay it off in full, the interest kicks in and the debt costs you more money.
- Personal loan – A loan from your bank or even a peer-to-peer lender may save you money. It depends on the interest rate charged. It also depends on the costs of the loan. Some lenders charge origination fees. Others charge processing/underwriting fees and closing costs.
- Home equity loan – A loan on your home often costs the most because of the term. If you take out a loan for 20 years, you pay interest over that time. This adds a significant amount to your debt. If you paid it off sooner with another method, you might save more money.
- 3rd party debt consolidation – Using a credit counselor may help you pay off your debt. Watch the fees, though. Even non-profit agencies charge for their services. Look for things like account set-up fees, monthly maintenance fees, and prepayment penalties. These fees can increase the amount you pay for debt significantly.
What is Debt Settlement?
Debt settlement is just as the name sounds. Creditors settle for a portion of the debt you owe them. Generally, you use this method with one creditor. However, you can use it for multiple creditors in some cases. This might sound like the best option, but understand how it works first.
You must negotiate with your creditors. You can do this yourself or with the help of a 3rd party. If you do it yourself, you offer a lesser amount than what you owe. The amount you offer must be an amount you can afford. You pay that lump sum to the creditor. Your account is then paid off. Most creditors will close your account.
Using a 3rd party can take the stress of negotiations off your shoulders. However, it comes with a cost. Most 3rd parties recommend that you stop making payments on your debts. This puts your accounts into default. Creditors are then more likely to negotiate. Letting your accounts go, though, means you’ll owe late fees and accrued interest. It also means creditors could place your account into collections. This could mean harassing phone calls and stress for you.
While you let your accounts go into default, debt management companies ask that you make payments to your account with them. They let the funds add up until you have enough for them to negotiate a settlement with one or more creditors. The cost of this service varies by company. Debt settlement companies can’t charge upfront fees according to the law. They can, however, charge a percentage of the settled amount.
The Consequences of Debt Consolidation
Consolidating your debt has consequences. Some good and some bad, just like anything else. The most common consequences include:
- You are only transferring debt – You really don’t get any further with your debt. You only transfer it from one bank to another. Until you make payments and make a dent in the debt, it still exists.
- You may free up credit balances – If you pay off credit cards with another loan, you have more credit that is available. If you are a spender, you might rack your credit up again. This only leaves you further in debt.
- Your home or car could be at risk – If you use a secured loan for debt consolidation, it puts your assets at risk. Consolidating a secured loan with another secured loan is one thing. Consolidating an unsecured loan or credit card debt with a secured loan is another. If you default on the loan, you could lose the collateral you promised.
- It may cost more – Depending on the method you choose, you could end up spending more on your debt. Interest charges, late fees, and annual fees all add up. Plus, you must consider the term of the loan. The longer you borrow the money, the more it costs in interest and fees.
The Consequences of Debt Settlement
Debt settlement has its own consequences. Again, there are some benefits. There are also some downsides. We cover both here:
- You can eliminate debt – If you are in over your head, this may be a good option. If your creditors willingly lower your debt, it’s gone. You aren’t transferring debt to another loan. They write it off. You only owe what they don’t forgive.
- You may ruin your credit score – Writing debt off isn’t good for your credit. Most creditors report this action to the credit bureaus. As a result, your credit score may drop. If it already dropped because you defaulted on your loans, you could have a rather low credit score.
- You may owe taxes – Forgiven debt is income in the eyes of the IRS. This means more taxes. You’ll have to claim the forgiven debt on your tax return for the year. This could increase your tax liability.
- You’ll pay for it – Companies don’t settle the debt for nothing. They have to stay profitable too. When you settle the debt, figure in the cost of the company settling it for you. For example, 20% on $10,000 equals $2,000. That makes your forgiven debt $8,000 rather than $10,000. Of course, that’s still a big number, but it’s something to think about.
- It takes time – It could take between 2 and 3 years to get creditors to settle your accounts. During that time, your fees add up. You then owe more than when you started the process. In the meantime, you do a number to your credit score if you aren’t paying your bills in an effort to get a settlement.
What Should You Choose?
Your financial situation will help you determine the right choice. Debt settlement is often the last resort before bankruptcy. Debt consolidation usually has a less dramatic effect on your credit report. It also keeps you honest. You still pay your bills, just in a more drawn out manner. If you can afford to keep paying your bills, debt consolidation may be a better option.
If, however, you just can’t get your head above water, settling may be your only choice. This way you still pay a portion of your debts. This differs from bankruptcy where you write your debts off entirely. Keep in mind, you can’t negotiate secured debts. Home and auto loans are a couple of examples. You can’t ask creditors to write those balances off. Instead, you can default on the loan and let them take your collateral in a foreclosure or repossession.
Weigh the pros and cons of each option. See how they will affect not only your finances, but your credit score too. Then you can decide which option works best. If you can manage either option on your own, you might save more money. There’s nothing wrong in asking for help, though. Look for non-profit credit counselors that can help you. They can look over your situation and decide which option works best. They can then do the negotiations for you. Sometimes a little experience goes a long way with creditors.
No matter which option you choose, work on your increasing your credit score right away. If you wipe the slate clean with debt settlement, don’t get back into debt. If you choose debt consolidation, make sure you make your payments on time. Similarly, don’t rack up your credit cards just because they are available. We don’t recommend closing your credit card accounts as that can hurt your credit too. Instead, lock your credit cards up and focus on making your other payments on time. Over time, your credit score will bounce back with the right habits.