Debt Settlement vs Debt Consolidation

Consolidate debt or Negotiate a Settlement? Learn the differences between each of these debt management options and which is best for your situation

As more and more consumers end up in debt with poor credit scores, many wonder whether they should join a debt management program. The real question is how best to get out of debt quickly without killing your credit score. Sometimes, that is possible, sometimes not. Here's some Pros and Cons of using debt settlement or a debt consolidation program:

Debt Settlement

Pros

• Debt is reduced by 40% to 80% of original owed amount.
• Debts marked as "settled" or "settled in full" or "paid in settlement".
• Freedom from debt in as little as 2 to 3 years.
• Huge interest savings.

Cons

• Temporary reduction to the credit score.
• Possible tax liability on cancelled debt over $600.
• Takes time and discipline.

Debt Consolidation

Pros

• Reduction in interest accrued, and possibly the interest rate.
• One payment compared to several.
• Freedom from debt in 3 to 5 years.
• Credit score not affected long term.
• All debts shown as "paid full" as they are satisfied.

Cons

• NO reduction in principal. Only interest rate.
• Possible "slow pay" status on credit report on some accounts.
• Must have enough equity to secure the consolidation loan.
• This is a SECURED LOAN. Possibility of losing collateral due to non-payment.
• Short term negative credit report impact.

Warning About Using Your Home Equity

When looking at debt settlement versus debt consolidation, it is important to know the facts. This way, you can select the option that fits your situation. Most people use their home equity to secure the consolidation loan, thereby putting their home at risk if they start to fall behind on house payments. Be sure you can make those payments without straining your household finances if you are leaning towards debt consolidation.

Debt Consolidation Considerations

Also be aware that debt consolidation does not reduce the principal of the accounts included in the action. Only the interest rate is reduced. This can be a significant savings considering the late fees and interest penalties associated with late or delinquent minimum credit card payments.

In other words, if you owe creditor A $5000 before consolidating, you will still owe them $5000 after you consolidate.

Debt Settlement Considerations

With a debt settlement solution, your principal amounts are reduced from 40% to 80% of the balance. This is in addition to the interest you will save long term. In the long run, debt settlement does not negatively affect your credit rating, although a short term drop in your score will probably happen.

When the debts are settled, all accounts are reported as satisfied to the three reporting bureaus. You are no longer deliquent, you have met your obligations under the settlement agreement. For this reason, there is no long term negative credit impact with a settlement.

The other thing you want to consider is whether you will have a tax liability on the reduced debts. The IRS views cancelled debt as taxable income. However, there is the insolvency rule whereby if your liabilities exceed your assets, then you are considered insolvent and there is no tax liability involved. Most people that choose debt settlement will NOT have a tax liability in this respect.

Consult an Expert

In either case, it is always safe to consult a financial expert to ensure you are not falling into a loophole somewhere. Consider all your options and seek professional advice before taking any action, especially when it comes to taxes.