What is debt consolidation and how is it different from debt settlement?

American consumers hit an important milestone this year. According to the Federal Reserve Bank of New York, credit card debt levels in the United States topped $1 trillion in the second quarter. Some of that is due to rising interest rates. Price increases due to inflation are also a factor. Monthly payments are higher, making it more difficult to make payments on time.

Economic conditions like this are a good time to review ways to pay off your debts. That list includes several types of debt consolidation and debt settlement. Debt consolidation is paying off high-interest credit card debts with a debt consolidation loan or line of credit. Debt settlement is settling for less than what you owe, but that could negatively affect your credit score.

Another form of debt consolidation is to transfer high-interest credit card balances to cards with a lower interest rate or zero-percent introductory APR. That’s more difficult than it sounds, and zero-interest offers are hard to come by these days. In this article, we’ll review that and other forms of debt consolidation, and we’ll explain how debt settlement works.

What is debt consolidation with a personal loan?

As of August 2023, the average credit card APR is just short of 21%. It’s expected to break that plateau within the next few months. The average personal loan interest rate is significantly lower. According to Bankrate, it currently sits at 11.31%. Taking out a personal loan to pay off credit card debt can save you up to 10% of your overall debt balance.

Loan terms differ from lender to lender and are affected by the loan applicant’s credit score. Individuals with lower scores may pay higher interest rates, just as those with higher scores will pay lower rates. On the flip side of that, every on-time payment on your debt consolidation loan should have a positive impact on your credit score.

Budgeting a loan to pay each month is simpler than budgeting for credit card bills because the interest rate on loans is typically fixed. That means paying the same amount each month instead of frequently adjusting your budget for variable interest and fees on credit cards. That and multi-year terms on loans are two of the more appealing features of debt consolidation.

What is debt consolidation with a line of credit?

Using a line of credit instead of a personal loan for debt consolidation can give you greater flexibility, but the interest rate equation can be more complicated. For example, a home equity line of credit (HELOC) has a draw period of five to ten years when you don’t need to worry about payments, but the interest rate on the principal is variable based on the prime rate.

There are other options if you have equity in your home. You could borrow against your equity to avoid the variable interest rate. Personal and home equity loans both offer fixed rates, but that doesn’t eliminate the risk that you’d take on with a home equity line of credit. A home equity loan is secured, so you’ll still face potential foreclosure if you default on it.

Making your line of credit repayments on time should positively affect your credit score, provided you don’t incur any other credit defaults or late payments. It will take more time to see that because the repayment period usually doesn’t start until after the draw period is over. If you’re able to, make principal payments during the draw period to accelerate that process.

What is debt consolidation with a balance transfer credit card?

Lowering your overall debt with balance transfers to low-interest or zero-interest credit cards is a form of debt consolidation. Finding credit cards that allow you to make those transfers is where the challenge lies. With interest rates rising almost daily at this point, few credit card companies are willing to offer deals that would cause them to limit their revenue.

Another challenge to finding a low-interest balance transfer credit card is that you generally need to have excellent credit to qualify for one. Even then, the lower rates are usually only for an introductory period of a few months up to one year. That puts pressure on you to pay off debt faster. If you can do it, it’s worth it. If not, that high credit score gives you other options.

A balance transfer to a lower-interest credit card, combined with a few on-time payments, can have a positive effect on your credit score because it will lower your balance at a faster rate than you’d be able to achieve with a higher-interest credit card. That doesn’t mean you should close those other card accounts. Leave them open to keep your available credit high.     

What is debt settlement and how does it work?

Do you ever receive emails from companies claiming to be able to “settle your debts” for “pennies on the dollar?” They might be legitimate, but debt settlement should only be considered if you’re in financial distress. It can ruin your credit and you might get a 1099-C from your creditors stating that you’ll need to pay income tax on the amount you didn’t pay them.

For those who are struggling, debt settlement is simply calling your creditors to let them know you cannot afford to repay them. They’ll usually listen if you’ve missed a few payments in a row. Many are willing to offer reasonable settlements because of the current economic conditions. New delinquencies on credit cards and auto loans rose to 7.2% in Q2.    

Which of these is the right choice for you?

Review each of these options carefully before you consider signing on the dotted line for a debt consolidation loan. Try to look at the whole picture, not just how much you’ll need to pay each month. Lower interest rates save you more money if you make higher or more frequent payments. Figure out what you can afford and base your decision on that. 

Don’t ignore the potential impact on your credit score. Agreeing to pay more than you can afford each month could lead to missed or late payments that will bring your score down. Paying on time, combined with lowering the amounts you owe, will increase your score. Debt settlement could do long-term damage. Avoid that if possible. Loans and lines of credit are better options.   

Kevin D. Flynn

Kevin D. Flynn

Kevin D. Flynn is a former financial professional, business coach, and freelance financial writer. He lives in Leominster, Massachusetts with his wife Evelyn, two cats, and ten wonderful grandchildren. When he’s not working, you’ll find him at the golf course or on his back porch reading classic sci-fi novels.

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