How to Choose Between Debt Settlement & Debt Consolidation

Each form of debt relief deals with the money you owe in different ways.

deciding between debt settlement and debt consolidation
Updated May 13, 2024
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Debt settlement and debt consolidation are different ways to cope with substantial debt. Both techniques aim to help you get out of debt. But there are big differences when it comes to debt settlement vs. debt consolidation.

Understanding how each process works and the associated risks is important to help you decide which repayment method is the best choice for you. While each can be beneficial, there are potential downsides to consider, too.

Here’s what you should know about debt settlement and debt consolidation before deciding if either option is right for you.

What is debt consolidation?

Debt consolidation is the process of getting a new loan and using funds from it to pay back multiple debts. By using one new loan to pay off existing loans, you consolidate debt — you don’t have multiple creditors to pay any more. Life is easier because you don’t have to keep track of all those different creditors, so you’re less likely to make mistakes, such as missing a payment.

Ideally, the new loan also has better terms for you as a borrower. You may have a lower interest rate, a different repayment timeline, and lower monthly payments. If you previously had a cosigner, the cosigner is also relieved of responsibility when you pay off the debt with the consolidation loan.

If you can get better terms on a consolidation loan, you reduce the total cost of repayment — which makes paying off the loan much cheaper, faster, and easier. You have a number of options for your consolidation loan, including:

  • Personal loans
  • Home equity loans
  • 401(k) loans
  • Balance transfers

You’ll need at least reasonably good credit to qualify for all of these types of loans at a reasonable rate so if you’ve missed payments or maxed out your credit cards, consolidation may not always be an option for you. And while you can also apply for a dedicated “debt consolidation loan,” you will have less choice of lenders with this option and may end up with a loan that isn’t as favorable. You should make sure to compare different loan options with different lenders to get the best rates and loan terms.

What is debt settlement?

Debt settlement is a very different approach to handling debt, and it’s imperative you really understand how debt settlement vs. debt consolidation diverge.

Debt settlement doesn’t involve taking out a new loan. Instead, it involves negotiating with one or more creditors to repay your current debt on different terms. Usually this means making a single lump sum payment for less than the amount owed on your debt. It could also mean negotiating a payment plan to pay a reduced amount with a lower interest rate or some fees or charges forgiven.

With debt consolidation, you’re paying your loan in full — but with debt settlement, you’re not. As a result, it can be cheaper to settle debt than to consolidate it. But debt settlement comes with major downsides.

For one, you’ll usually need to be behind on payments to get creditors to agree to settle debt — and late payments hurt your credit. If you’re making all your payments, there’d be little reason for the creditor to accept a settlement offer. Your debt will likely also be listed as settled on your credit report, which further damages your credit score. You could be taxed on the forgiven amount of debt, which means getting hit with a big IRS bill. And you’ll also typically have to agree to stop using your accounts, which means you cut off access to your credit.

Debt settlement can be a good approach when your debt is truly unaffordable and when you might otherwise need to file for bankruptcy. But you should consider consolidation first if it’s feasible to protect your credit. You’ll also need to be prepared to negotiate effectively with creditors to settle your debt. There are companies that do this for you, but many are unscrupulous and charge high fees. So be very careful if you consider enlisting help.

Debt settlement vs. debt consolidation

Now you know more about what debt consolidation and debt settlement are, but what is the difference between debt consolidation and debt settlement?

There are a few key differences.

First and foremost, there’s a difference in who qualifies. To get a consolidation loan, you’ll need at least reasonable credit. And good or excellent credit is best to qualify for a new loan at the most favorable rates. When you settle debt, on the other hand, you don’t need to have good credit. In fact, in most cases, your credit score will be poor because you’ll need late payments before a creditor agrees to settle debt.

Debt consolidation also involves paying back the full amount you owe — albeit ideally paying less interest than you would have if you hadn’t consolidated. In contrast, debt settlement involves paying back less than the full amount.

Settlement hurts your credit because you aren’t fulfilling your borrower obligations, while consolidation can help your credit because you get a new type of loan on your credit report. Having a mix of different credit can raise your score. You’ll also develop a positive payment history in paying down your consolidation loan and will free up your credit accounts. This may help your credit utilization ratio — which is important because payment history and a low utilization ratio are also important factors in your credit score.

Finally, with debt settlement, you usually have to agree not to use your accounts anymore as part of your settlement agreement. With debt consolidation, on the other hand, paying off existing credit card debt could free up more available credit if you need to use it. Of course, this means you need to be careful not to get deeper into debt because you now have all this new access to credit.

Debt Settlement Debt Consolidation
What is it? A negotiated plan with creditors to pay your debt for less than you owe Taking out a new loan to repay multiple existing debts that ideally has better repayment terms
When is it useful? When you’re behind on your debt and cannot afford to pay back the full amount you owe When you want to make debt repayment cheaper and easier
How much debt does this repay? Creditors accept partial payment and forgive the remaining balance. The full amount you owe — ideally at a lower interest rate
Is there a fee? Only if you use a debt settlement service Only if your new consolidation loan charges origination fees
What credit score is needed to qualify? Your credit isn’t applicable Good enough credit to qualify for a loan. The score you need varies depending on type of consolidation loan. The better your score, the better the terms of your loan.
How long does it typically take? A few months or longer; you’ll need to first be behind on payments, then negotiate a deal. If you agree to a payment plan instead of a lump sum payment, it could take months or years. A week or two to get a new loan and repay existing creditors. Consolidation loans are often repaid over several years.
Can you continue to use your accounts? No Yes
How it affects credit Your credit score is damaged by late payments and by a notation that your debt was settled. Your credit could improve as you get a new type of credit on your report, pay down debt, and make payments on time.
Are there tax implications? Yes No
Is it guaranteed to work? No; creditors may not agree to settle debt Yes, as long as you qualify for a new loan and pay it back.

How to decide what’s right for you

If you’re able to afford to pay back your debt and you can qualify for a consolidation loan at a reasonable rate, this is almost always the better choice. After all, you get to fulfill your obligations to your creditors, protect or improve your credit score, and potentially lower your total debt repayment cost.

But if you can’t qualify for a consolidation loan and are unable to figure out how to pay off debt, debt settlement could be a good solution — as long as your creditors are willing to work with you.

Alternative ways to get out of debt

While debt settlement and debt consolidation are both techniques you can use to get out of debt, you don’t have to choose either one. After all, debt settlement hurts your credit while consolidation is just moving debt around — you still have to find a way to pay it off. You run the risk of ending up deeper in debt with a consolidation loan if you don’t have your spending under control and a clear payoff plan.

You could also just keep your debt with existing creditors and make extra payments under a debt repayment plan, such as the debt snowball or debt avalanche method.

The debt snowball involves making extra payments to your debt with the smallest balance first until that’s paid off, then moving all those extra payments to the next smallest debt until you’re debt-free. The debt avalanche involves putting your extra payments towards the debt with the highest interest rate, then the next highest rate, and so on. The snowball method has been proven effective because it helps you stay motivated, while the avalanche provides the most savings since you get your high interest debt paid off ASAP.

The important thing is to pick some type of plan to deal with your debt, whether that’s consolidation, refinancing, the snowball, the avalanche, or finding another way to become debt-free. The longer you’re in debt, the more interest you’ll pay — and the harder accomplishing your financial goals will be.

National Debt Relief Benefits

  • No upfront fees1
  • One-on-one evaluation with a debt counseling expert
  • For people with $30,000 in unsecured debts and up

Author Details

Christy Rakoczy

Christy Rakoczy has a Juris Doctorate from UCLA Law School with a focus in Business Law, and a Certificate in Business Marketing with an English Degree from The University of Rochester. As a full-time personal finance writer, she writes about all things money-related but her special areas of focus are credit cards, personal loans, student loans, mortgages, smart debt payoff strategies, and retirement and Social Security. Her work has been featured by USA Today, MSN Money, CNN Money and more, and you can learn more at her LinkedIn profile.