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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 situation to consolidate or settle debt. Depending on your overall finances, your credit score, the amount of debt, and other factors, debt consolidation or settlement may or may not help.
Here, we explore debt consolidation, debt settlement, and how to decide which approach, if any, is most beneficial 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. Some of the most common ways to consolidate debt are 0% balance transfer credit cards and debt consolidation loans, or personal loans, from a bank or credit union.
Typically, with debt consolidation, your old debt is paid off by the new loan. For example, if you currently owe a total of $ 15,000 on three different credit cards, you could get a personal loan of $ 15,000 and then pay off the balances on those three credit cards with your new loan funds. You will still owe $ 15,000, but the debt will be in one place with one monthly payment and possibly at a lower interest rate. When a debt consolidation loan has a lower interest rate, you can pay off the debt sooner and at a lower total cost.
It is important to remember that you will always owe the same amount of principal balance if you choose debt consolidation. And, if you decide to continue to borrow money on top of your consolidated debt, you could run into financial hardship.
Debt consolidation can provide more visibility and control over your debt. Combining all of 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 different circumstances:
- You want to simplify your debts. Instead of multiple debts and multiple monthly payments, you can combine your debts into one. If you’re having trouble making a lot of monthly payments, debt consolidation might 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 the consolidated debt. For example, if you can combine multiple high interest credit card balances on a 0% APR balance transfer credit card with limited duration, it can help you pay off your debt faster.
- You are ready to make a plan to pay off your debts. Even if you’re not under financial stress, debt consolidation can help you get your debt under control or pay it off completely. If you want to focus on paying off your debt, debt consolidation can help you lower your interest rate, better organize yourself to pay off your debt, and improve your financial situation.
Alternatives to debt consolidation
Debt consolidation is something you manage on your own. But you might need a different 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 making 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 full amount of debt, but they help you make a plan to pay off your debt, while potentially helping to lower fees and costs.
Debt settlement is another form of debt relief that is sometimes compared to debt consolidation, but it’s quite different. Unlike debt consolidation, where you ultimately pay off your entire debt balance, debt settlement is a form of debt forgiveness where your creditors agree to let you pay less than what you owe.
Settling debts can be risky and is generally seen as an option of last resort. If you’ve exhausted all other options, debt settlement may seem like the right way. Even then, many experts advise exploring other options.
Indeed, it is important to be aware of the risks. Debt settlement usually involves becoming overdue on your bills and then settling with creditors a lower percentage of what is owed. This can damage your credit score and show up on your credit reports for up to seven years. There is no guarantee that your creditors will agree to settle your debts. If you are successful in obtaining debt forgiveness, the forgiven amounts can become taxable income which is reported to the IRS, requiring you to pay taxes on the forgiven amount.
Debt settlement is an option that you can handle on your own if you are comfortable talking with your creditors and asking them to come to an agreement on your debts.
There are also debt settlement companies that will offer to negotiate for you with your creditors in exchange for fees, which often represent 15-25% of the total debt listed. As part of the debt settlement process, these companies will ask you to make payments into a separate account that they have created for you. This money is then used to pay off your debt amount after negotiations with the creditors.
When debt settlement makes sense
Settling debts can be risky and complex. Often there is a better alternative, but if you think you’ve exhausted all other options, here’s 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 more loans, and can’t qualify for a low-interest debt consolidation loan or credit card with balance transfer, you might consider settling your debts.
- You don’t want to file for bankruptcy. If you are unable to file for bankruptcy or if you 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 taking a hit on your credit report due to delinquency, you can proceed with your debt settlement.
Alternatives to debt settlement
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 becoming past due on your debts and potentially taking a hit on your credit score, consumer credit counseling can help you stay up to date on your bills and pay off your debts without the potential risks and consequences. long term debt settlement.
Debt Consolidation vs. Debt settlement
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Frequently Asked Questions (FAQ)
How Does Debt Consolidation Work?
Debt consolidation involves 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 debt. You could get a debt consolidation loan of $ 15,000. After you’ve paid off your pre-existing debts with your new debt consolidation loan, you make a one-time payment on your new loan each month.
What is a consumer credit counseling service?
Consumer credit counseling organizations are typically non-profit organizations with certified and trained counselors. These advisors can help you manage your money and debt, create a budget, and educate you on financial matters.
Some credit counseling agencies will help you create and implement a debt management plan for your debts. With this type of plan, you always pay the full amount of principal 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 DIY 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 can agree to take 40-50% of what you owe.
It’s important to remember that most creditors won’t negotiate or settle a debt unless you are significantly behind in payments. And keep in mind that the debt settlement process can take anywhere from two to four years, depending on your overall debt amount and the complexity of your situation.
How Does Debt Settlement Affect My Credit Rating?
Settling debts can hurt your credit score because the process forces you to stop paying your bills and become past due on your debts. Along with the blow to your credit, some creditors may refuse to negotiate with you and could sue you for non-payment and garnish your wages. For these and other reasons, debt settlement can be risky and is not an ideal option.