Debt Consolidation vs. Debt Settlement: Weigh Your Options
Getting yourself out of debt requires a strategy. Debt consolidation and debt settlement are two ways you can go about it. Debt consolidation is almost always the better choice.
Debt consolidation doesn’t change how much you owe, but you might save by getting a lower interest rate. However, you usually need at least good credit for this tactic to work.
On the flipside, you could get some of your debt forgiven with debt settlement. Here, you’ll negotiate with your creditors to reduce what you owe. But your creditors may not be willing to settle. If they are, you might face a hefty price tag and a ruined credit score.
What is debt consolidation?
- Have good to excellent credit
- Qualify for a lower interest rate on a debt consolidation loan
- Can afford to pay back what you borrowed
- Have multiple credit card and personal loan bills each month
Debt consolidation is the process of taking out a new loan or line of credit and using it to pay off multiple debts. Consolidation doesn’t reduce the amount you owe, but it restructures it.
People generally consolidate debt for two reasons. First, debt consolidation can make handling your budget easier. Instead of juggling multiple monthly credit card bills, you’ll only have your consolidation loan to pay.
Consolidating might also save you interest if you’ve improved your credit score since taking on your original debt.
As of this writing, the average credit card interest rate in the U.S. stands at 24.80% (the highest since 2019, the year LendingTree started tracking this data). We also show that the average annual percentage rate (APR) for personal loans closed with LendingTree is 18.66% (for credit scores 720 and above).
Now imagine you have five credit cards with an average combined APR of 25%. You have $10,000 in total debt. You also qualify for a debt consolidation loan with a 19% APR. You’d pay roughly $7,610 in interest if you paid your cards off over five years. If you consolidated, you’d pay about $5,564 — a savings of almost 27%.
Types of debt consolidation
Debt consolidation loan: A debt consolidation loan is a type of personal loan. These come as a lump sum of money, and you’ll pay it back in equal monthly installments, plus interest. Debt consolidation loans are usually unsecured, meaning they don’t require collateral.
Balance transfer credit card: A balance transfer lets you move existing credit card debt to a new card, hopefully at a better rate. Some balance transfer credit cards have 0% APR introductory periods, but these usually require at least good credit.
Home equity loan or home equity line of credit (HELOC): You could take out a home equity loan or HELOC to pay off debt. However, these use your home as collateral. If you fall behind, you could lose the roof over your head. At the same time, rates are generally low, since there’s less risk for the lender.
Cash-out refinance on your mortgage: A cash-out refinance lets you take out a new, larger mortgage on your home. The cash-out refi will pay off your existing mortgage and allow you to pocket the overage (which you could use to pay debt). Like the options above, cash-out refinances are risky because your home is collateral.
401(k) loan: A 401(k) loan lets you borrow from your retirement plan, and you’ll pay yourself back interest. Generally, 401(k) loans don’t require a credit check, but you might only have a few months to pay back your loan in full if you leave your job during repayment.
Pros and cons of debt consolidation
Debt consolidation is popular. In the first quarter of 2024, 55.1% of LendingTree users used their loans for debt consolidation. Still, like other personal finance tools, debt consolidation has positives and negatives.
| Pros | Cons |
|---|---|
Lower interest. Your APR on a debt consolidation loan might be lower than what you’re currently paying (if you have strong credit). Streamlined billing. After you consolidate, you’ll only have one debt payment each month. Could get you out of debt faster. A shorter term on a debt consolidation loan means you could be out of debt sooner. | Doesn’t eliminate debt. You’ll still pay the full balance of what you owe if you consolidate. Origination fees. Lenders sometimes keep a portion of your loan for themselves as an extra charge (called an origination fee). Usually requires at least good credit. You might not qualify for a better APR on a consolidation loan if you have bad credit. |
What is debt settlement?
- Are comfortable taking the DIY route instead of hiring a debt settlement company
- Have more debt than you can handle
- Already have a low credit score
- Will save money by settling, even considering fees, interest and tax implications
- Don’t qualify for Chapter 7 and don’t want to file for Chapter 13
Debt settlement (also called debt relief) involves negotiating with your creditors to reduce the amount you owe. The thought is that your creditor would prefer some sort of payment rather than nothing at all.
We generally don’t recommend debt settlement, but there are two ways to go about it. You can do it yourself, or you can hire a professional debt settlement company.
But no matter the path you take, your creditor might not be open to negotiating. The power is in your creditors’ hands, not yours or those of a debt settlement company.
Typically, creditors may be more willing to negotiate if it has already charged-off your debt. At this point, your creditor has determined that you’re probably not going to pay what you owe, but it hasn’t sent your debt to collections.
DIY debt settlement
If you believe that debt settlement is right for you, handling negotiations yourself could be the better option. It can be time consuming, but doing it yourself allows you to skip the fees that debt settlement companies typically charge.
If your creditor hasn’t charged-off your debt, you’ll probably work with your creditor itself. If your creditor has sent your debt to collections, then you will negotiate with a debt collections agency or law firm.
Professional debt settlement
On average, the professional debt settlement process takes three to four years.
When you hire a professional debt settlement company, it will usually direct you to stop making your debt payments. Instead, you’ll put that money into a dedicated account. Once you’ve “saved” enough money, the debt settlement company will use the account to negotiate.
Whether or not the debt settlement company is successful, it will still charge you a fee for its service. These fees generally range from 15% to 25% of the total debt settled.
The risks of debt settlement
Debt settlement affects your credit over time. Depending on your financial situation, debt settlement might not be worth it.
There’s no guarantee debt settlement will work. Your creditors decide whether they will settle, and for how much. Not only that, debt settlement scams are common. If you aren’t careful, you could hand over your hard-earned money and get no results.
May make it hard to borrow in the future. Even if your creditor is open to working with you, your settled payment will show as “settled” on your credit reports. This is a signal to future lenders that you weren’t able to pay your full balance.
Can tank your credit score. You might stop paying your creditors during the debt settlement process. This delinquent debt could show on credit reports for up to seven years, even after you’ve paid (or settled) it.
You might end up with more debt than when you started. When you stop making payments, interest and late fees will begin to accrue. This is true even if you’re in the debt settlement process. Interest and fees might even cause you to exceed your credit limit, which could trigger even more fees.
You could be at risk for a lawsuit. The collection process doesn’t stop when you work with a debt settlement company. Failing to make regular payments could get you sued by debt collectors.
You might have to pay more in taxes. Generally, the IRS counts settled debt above $600 as income. For example, if you settle $10,000 of credit card debt for $3,000, you’ll owe federal taxes on $7,000.
Debt consolidation vs. debt settlement: Which is better?
Whether you choose debt settlement vs. debt consolidation depends on your financial situation.
Debt consolidation is better if you have solid credit, can afford your debt and can get a lower APR on a personal loan.
Debt settlement could be worth considering if you are behind on payments, have bad credit, can’t afford your debt and don’t want to file for bankruptcy.
The factors below might help point you in the right direction. Note that this table highlights debt consolidation loans instead of other consolidation options like balance transfer cards.
| Factors to consider | Debt consolidation | Debt settlement |
|---|---|---|
| Credit score requirements | Usually need good to excellent credit for a debt consolidation loan to be worth it | Typically no credit score requirements |
| Amount of debt that you will repay | All, but you might save on overall interest | All or some, depending on if your creditors will negotiate |
| Fees | Some loans have origination fees that can run up to 10.00% (or higher), although no-fee personal loans exist | Debt settlement company fees can be between 15% and 25% of the debt settled (not including late payment fees or accrued interest) |
| Effect on credit score | Might hurt credit initially (due to a hard credit hit), but on-time payments could improve your score over the long run | Expect a dramatic drop — settlements and late payments show on your credit reports for up to seven years |
| Tax implications | None | Settled debt over $600 counts as taxable income |
| Account status after pay off | Can continue using cards after you consolidate | Credit cards are closed if settled in full |
How to consolidate your debt with a personal loan
- Check your credit score. Use LendingTree Spring to check your credit score for free. You’ll need it to figure out if your credit is good enough to work pursuing debt consolidation. Generally, you’ll need a credit score of 720 to get a personal loan rate that’s lower than the average credit card.
- Add up what you owe. Gather all of the credit card and personal loan bills you’d like to consolidate, and calculate your total debt. This is the amount you’ll need to consolidate. Also, take note of APRs and repayment terms.
- Prequalify and compare offers. Prequalifying for a personal loan helps you check rates without hurting your credit score. Make sure your APR is lower than the average of what you’re paying across your cards.
- Consolidate and repay. If the lender approves you, it might offer to send your loan directly to your creditors. Many (like Achieve) will give you an APR discount for doing so. And since it’ll skip your hands, you can avoid the temptation to spend your loan on unrelated things.
How to attempt a DIY debt settlement
- Do your research. Instead of hiring a for-profit debt-relief company, learn how to settle debts yourself. Consider the strategies below:
- Offer a lump-sum payment. The credit card company might agree to reduce the amount you owe.
- Ask for a workout agreement. A workout agreement permanently changes your cardholder agreement. Your issuer might lower your APR or minimum monthly payment.
- See if forbearance is an option. Forbearance could temporarily pause your payments (but interest may still accrue). Creditors might be more inclined to offer forbearance if you haven’t yet missed a payment or aren’t that far behind.
- Gather documents. Your creditor might be willing to settle if you can provide a reason for your financial hardship. If you’ve been laid off or had to take an extended leave of absence, show them paperwork to back up your claim.
- Move cautiously. We strongly advise you to continue making your current credit card payments. If you stop, make sure that you are fully aware of the interest, fees and credit score impact that will follow.
- Get it in writing. Don’t count on your call being recorded. Make sure your credit card company sends you the terms of your new agreement.
Alternatives to debt consolidation and debt settlement
Debt avalanche or debt snowball
The debt avalanche and debt snowball methods are budgeting tools that can help you pay off what you owe faster, and with less interest. Both are about equally effective, so the one you choose boils down to personal preference.
By following the debt avalanche method, you’ll focus on paying your highest-interest debt first, regardless of balance. The debt snowball method, on the other hand, means you’ll pay off your smallest debts first, ignoring interest rates.
Debt management plan
You could work with a nonprofit agency and come up with a debt management plan. This works best when you’re ready to examine (and change) your financial habits. Although you’ll pay the full amount you owe, you could be out of debt in three to five years. You also can’t use (or open new) credit cards while under the plan.
You’ll work with a certified credit counselor who will attempt to negotiate your interest rates and fees. Your credit counselor will collect your payment and pay your creditors on your behalf. Debt management plans can come with monthly and set-up fees (which usually cap at around $75).
To find help near you, please visit the U.S. Department of Justice’s credit counseling agency database.
Bankruptcy
If it’s clear that you’ll still have more debt you can handle no matter what choice you make, it might be time to think about bankruptcy.
You might be a good candidate for Chapter 7 bankruptcy if you have few assets and are lower income. Also called liquidation bankruptcy, Chapter 7 requires you to sell certain possessions and most of your debts are forgiven.
Under Chapter 13 bankruptcy, you can keep your assets. However, all of your disposable income will go toward repaying your debt. You’ll follow a strict repayment plan for three to five years, and you may or may not be required to pay off all of what you owe.