What is the difference between debt consolidation and debt settlement?
In a debt consolidation, you would consolidate several of your loans into one loan and one monthly payment. This process may lower your interest rate and extend the life of the loan, thereby giving you a lower monthly repayment amount.
A debt settlement may change the interest rate and debt owed. For example, if you owe $50,000, you may be able to “settle” the debt for $25,000 with the creditor, so that once you repay $25,000, your loan is considered paid off.
Credit Image: Orin Zebest on Flickr
How do debt consolidators and debt settlement firms make their money?
Although some groups operate on a nonprofit basis, many companies are for-profit. Debt consolidators and debt settlement companies will charge you a monthly fee or a one-time fee (or both) to administer your loan and help you work out a deal with creditors.
Consumers will make one payment to debt consolidators, who will take a monthly fee and then pass on the rest of the payment to creditors. In the case of debt settlement firms, some will take a monthly fee while others will take a percentage of the debt settled. David Johnson, a financial expert, told The New York Times that he recommends consumers look for “services that charge after settlement, about 20 percent of the amount of the negotiated reduction in balance.” This way, the incentives between debt settlement companies and clients are aligned.
Should you use a debt consolidator or debt settlement firm?
Debt consolidation and debt settlement is not a cheap process, but it could be a way out of sustainable debt. Be sure to evaluate the fees carefully and determine whether if would make financial sense to enter in such an agreement. In case of debt settlement, most companies would instruct you to stop sending in minimum payments until they reach a negotiated settlement with the credit card companies. This would have an adverse effect on your credit history and may increase credit card fees and penalties if a settlement is not reached.
If you can file for Chapter 7 bankruptcy, that would be a quicker and cheaper way to wipe away most of your credit card debt. If you are morally opposed to bankruptcy or do not qualify because of income requirements, debt settlement and consolidation would be something to consider. Many debt consolidators may also forbid clients to open up new lines of credit until their debt is repaid, helping to keep them from descending further into credit card debt.
This is a lightly regulated industry, so be sure to do your research, read the contracts, and understand the terms before you sign an agreement to work with a debt consolidator or a debt settlement firm. The Federal Trade Commission offers some guidelines on debt settlement firms and fraudulent practices. The Better Business Bureau is another resource to check on the rating and reviews of potential firms.
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