You’re late on most of your debt payments. One by one, your accounts are being turned over to collections. Not a day goes by without a phone call from an aggressive debt collector or two. You’re simply in over your head.
Where do you turn if you’re in a situation like this?
When you have too much debt to deal with, you may want to look into debt settlement or debt consolidation. These two very different solutions may help you cope with your payments and start digging out of debt. Both options, however, are fraught with pitfalls.
What is Debt Settlement?
Debt settlement is the process of settling — or paying off — a debt, usually for less (often much less) than what you owe. You can try to settle your debts on your own, or you can work with a reputable debt settlement company.
There are plenty of situations in which a lender will settle a debt for less than you owe. If, for instance, the debt has been turned over to a separate collections agency, you can probably settle for 15 to 30 percent of your debt balance.
These collections agencies often buy bad debt from lenders for pennies on the dollar. Even if you pay them only 20 or 30 cents on the dollar, they make a profit.
Also, if you’re absolutely on the verge of bankruptcy, many lenders will agree to settle your debts. They know that if you file for bankruptcy, they’re likely to get nothing from you. So rather than forcing your hand, they’ll take less than what you owe.
Let’s say you have three credit cards with balances of $5,500, $3,000 and $12,000. You can’t afford to make even your minimum payments, and you’re behind on all of them. By working directly with debt collectors or through a debt settlement company, you may be able to settle these debts for maybe $1,100, $900, and $1,800.
Pros and Cons to Consider
Debt settlement, unlike consolidation, gets rid of your debt. However, there are some potential negatives to consider, including:
- Debt settlement can take 18-48 months. The long negotiation process, during which your accounts are becoming more and more delinquent, can really ding your credit score.
- If a debt settlement is reported to credit bureaus, it could take anywhere from 105 to 125 points off your FICO score, and the settled account will be listed in your reports for years. (Bankruptcy would be even harder on your credit score, so if debt settlement keeps you from going into bankruptcy, it’s usually the better option.)
- There may be tax implications to debt settlement. The money you no longer owe your lender will be listed as forgiven debt. You may have to claim that forgiven debt as income, meaning it could increase your income taxes for the year. (Note: For 2013, at least, some forgiven mortgage debt can be excluded from this requirement.)
Debts to Settle
You’re most likely to be able to settle unsecured debts, those that aren’t backed by any personal assets such as your home, car or other collateral. Medical debts and credit card debts that you’re struggling to pay, or that you haven’t paid on in ages, are usually the easiest to settle.
You can sometimes effectively settle secured debt by completing a short sale. If you’re behind on your mortgage payments, for instance, a short sale could be the way to settle your mortgage debt. Say you owe $200,000, but can only sell your home for $175,000 in this market. Your mortgage lender knows that if it forecloses on your home, it’ll probably lose more than $25,000 on that mortgage. So it’ll take whatever you can get on your home and forgive the rest.
On the flip side, federally secured debts, like student loans, are virtually impossible to settle. Since they’ll eventually get their money, lenders will just keep coming after you until you pay.
Should You Use a Debt Settlement Company?
While there are many debt settlement scams out there, some legitimate debt settlement companies do exist. Whether you should work through a company or on your own is a personal choice.
Certainly, consumers can settle their debt directly. To do so, you’ll need to figure out how much you can afford to pay on any given debt, and you’ll keep offering the company (or collections agent) that amount of money to settle the debt. It may take months of missed payments, though, and you’ll have to stand firm.
Going through this process can be scary, especially as you watch your credit score plummet as you miss payments. If you need some extra help, a debt settlement company may not be a bad option. Just be sure you find a reputable company and find out up front what the settlement process will cost.
According to one Federal Trade Commission report, fraudulent debt settlement companies will charge exorbitant fees, up to 30 percent of the total debt balance, to settle your debts for you. Legitimate companies that are genuinely interested in helping consumers will charge much lower fees than this and will be honest about all the fees and surcharges they’ll require.
What is Debt Consolidation?
Debt consolidation, on the other hand, doesn’t get rid of your debts. It brings all your (often high interest) debts under one lump sum debt. Basically, you take out one new loan that you then use to pay off other loans. The new loan will often lower your monthly payments, giving you some breathing room in your budget.
Consolidating your debts isn’t usually as difficult as settling them because the lenders are being paid off. You’ll just have to find the right consolidation solution for you. You may consolidate debts through an unsecured consolidation loan, a credit card balance transfer, a federal student loan consolidation loan, a peer-to-peer loan, or even a home equity loan or line of credit.
Pros and Cons to Consider
As I said, debt consolidation doesn’t get rid of debt. This makes it problematic for some consumers, who use their lowered consolidation loan payments as an excuse to rack up more debt. Also, if you turn unsecured loans — student loans, credit cards, personal loans, etc. — into secured loans, you risk losing the loan collateral (like your home or car) if you can’t make payments on time.
With that said, there are plenty of advantages to debt consolidation:
- Consolidating your debts shouldn’t have a negative effect on your credit score. In fact, if loan consolidation allows you to pay down high credit card balances and stay on top of your monthly payments, it may have a positive effect on your credit score.
- Debt consolidation may give you lower monthly payments and more manageable interest rates, especially if you use a consolidation loan to pay down high-interest credit card debt.
- There may be tax advantages to a consolidation loan. At the very least, you won’t have to pay taxes on forgiven debt, since none of your debt will actually be forgiven. But if you use your home’s equity to pay off other debts, you may get the tax write-off for paying mortgage interest.
Should You Work with a Debt Consolidation Company?
Again, whether you work with a specialized company to go through this process is up to you. If you have decent credit, you can probably get a debt consolidation on your own, without paying third party fees.
If you have a lot of equity in your home, shop around for a home equity loan, or look into a cash out refinance that would give you the money to pay down debts. Just be cautious about how much money you borrow against your home’s value. Remember, if you can’t make payments, your home could be placed in foreclosure.
Another place to begin is with a peer-to-peer lending operation, like Prosper or Lending Club. They’ll often offer a relatively low interest rate loan that you can use to pay down higher-interest credit card debt.
While you have plenty of options for consolidating loans, if your credit is shot, these options may not work for you. In this case, working with a debt consolidation company may be a good idea. Again, be sure to do your due diligence when you select a company and make sure you understand the process and all the fees and charges up front.
Which is the Best for Your Situation?
Choosing between debt consolidation and debt settlement can be tough, especially if you’re feeling the pressure from your debts or missed payments.
In general, debt settlement is best if you have so much debt that you can’t see the light at the end of the tunnel. Even with paying taxes on forgiven debt and possibly paying a settlement company’s fees, debt settlement could save you thousands of dollars. Plus, it gets that nasty debt off your back so that you can begin rebuilding your financial future.
If you do have enough money to eventually pay off your debts, but you’re struggling with high interest rates or minimum payments, debt consolidation is probably a better option for you.
In either case, you need to make sure that debt settlement or debt consolidation is only one part of a larger overall financial management plan. After all, if you need either of these options, you’ve most likely made some bad choices in the first place.