What’s the Difference Between Debt Consolidation and Debt Settlement?

Quick Answer

Debt consolidation is when you take out a new loan to pay off multiple debts, ideally at a lower interest rate. Debt settlement is when you hire a company to negotiate your debt and pay less than you owe. Overall, debt consolidation is a safer option for your credit score.

Young couple contemplating finances at their kitchen table.

When you're looking into strategies to better manage your debt payments, you may come across both debt consolidation and debt settlement as options. Both of these strategies may reduce the cost of your debt, but they do so in different ways.

Debt consolidation is when you pay off existing debt with a loan or credit card, and debt settlement involves negotiating to pay off debt for less than you owe. Here's what you need to know to decide between debt consolidation and debt settlement.

What Is Debt Consolidation?

Debt consolidation involves borrowing money to pay off your current loans, credit cards or other debts, typically at a lower interest rate. Consolidating debt reduces your debt repayment to a single scheduled payment, which can be easier to manage than making payments of differing amounts to several creditors.

You can consolidate debt with a personal loan (also called a debt consolidation loan) or a balance transfer card. You can apply for a debt consolidation loan through an online lender, peer-to-peer lending platform, bank or credit union. Debt consolidation loans often have lower interest rates than credit cards, making them an ideal way to reduce the amount you pay in interest.

Balance transfer credit cards are another way to consolidate debt. You can save money by transferring current credit balances to a balance transfer card with a lower interest rate. You may also receive a 0% APR introductory period of up to 21 months, which can help you pay down your balance without accruing more interest.

Debt consolidation makes it possible to reduce your payments, streamline your cash flow and pay your debts in full. As you pay down your debts, you could improve your credit score in the process. But be aware, debt consolidation options may require an already good credit score and can come with expenses, such as a balance transfer card fee of 3% to 5%.

What Is Debt Settlement?

Debt settlement is when you hire a company to negotiate with your creditors to pay off your debts for less than you owe. Debt settlement typically requires that you withhold payments to your creditors. Nonpayment is then used as leverage to negotiate a settlement amount, with the idea that the creditor would rather settle for less than get nothing.

This can have a serious impact on your credit score, however. Debt settlement is a risky option to reduce your debt due to the potential that it will damage your credit score. Withholding payments can result in late payments on your credit report, defaults and eventual charge-offs. Even if the settlement is successful, it will be noted on your credit report that the account was settled for less than originally agreed. All of these derogatory marks on your report can lower your score.

Debt settlement also comes with increased costs. Debt relief companies typically charge approximately 15% to 25% of the total amount the debt settlement company is handling (not the amount forgiven). They may also charge a fee for administering the savings account that you keep your settlement amount in.

Finally, you may receive a tax bill for the forgiven amount. That's because this balance is treated like taxable income.

What's the Difference Between Debt Settlement and Debt Consolidation?

The main difference between debt consolidation and debt settlement is that debt consolidation is a safe way to reduce your interest rate while still paying off your complete principal balance. Debt settlement is a riskier way of reducing your debt by only paying part of your principal.

Debt Consolidation vs. Debt Settlement
Debt Consolidation Debt Settlement
Pay off your principal in full. Pay a lower amount than owed.
Reduce payments by taking a loan with a lower interest rate. Reduce debt by settling with creditors.
Keep making one payment that consolidates multiple lines of debt. Stop making payments now, start saving for settlement amount.
Can help improve your credit score by:

  • Paying off your whole debt.
  • Possibly enhancing your mix of credit accounts.
  • Making it easier to keep up on-time payments with one payment versus many.
Likely harms your credit score due to:

  • Missed payments that occur.
  • Charge-offs that may occur when accounts are closed.
  • The creditor settling for less than is owed on the account.

When Should You Consider Debt Consolidation?

Debt consolidation may be right for you when:

  • You could use the breathing room of reduced interest rates
  • You could benefit from one payment versus several
  • You have good enough credit to get approved for a lower-interest loan
  • You have debt from multiple sources such as a car loan and credit cards

When Should You Consider Debt Settlement?

Debt settlement should be considered a last resort option due to the damage it could do to your credit score. It may still be a better alternative than bankruptcy, which can severely damage your credit for up to 10 years.

The Bottom Line

If you are looking for a way to reduce your debt, both debt settlement and debt consolidation can keep more money in your wallet. But debt consolidation offers a way to do so without damaging your credit significantly in the process. Start the process by investigating debt consolidation with loans matched to you or balance transfer credit cards.

Get started on your debt repayment process by getting a free credit report from Experian so you know exactly which accounts you have open and how much you owe.