Consumers are easily confused about how debt consolidation works because the industry uses interchangeable terms.
A debt consolidation loan means that one new lender pays off what you owe to multiple old creditors.
A debt settlement program means that you consolidate your payments to multiple creditors in an effort to negotiate relief.
Both approaches work very differently and have unique pros and cons. Explore both alternatives to decide which is best for your needs.
How Debt Consolidation Loans Work
Debt consolidation loans work by combining multiple obligations. You pay off several balances with one new contract. You then repay one creditor each month instead of several. The new loan may have longer repayment terms and lower interest rates – but not always.
The three possible advantages of debt consolidation loans are smaller monthly payments, lower interest rates, and credit score help.
- Smaller monthly payments are more affordable and provide more breathing room. Most people lower their payments by stretching out the repayment terms over a longer period. This helps payday borrowers most.
- Lower interest rates can also lower the monthly payment and/or help you reduce your bills. However, only people with top-notch credentials lower rates.
- The effect on credit scores is positive when more affordable payments avoid delinquency, and as the principal owed declines.
Debt consolidation loans have four big disadvantages. They do not reduce the amount owed, it is difficult to qualify, they usually add to interest costs, and you can make matters worse.
- You still owe the same amount of money. Consolidation loans restructure your balances. The new combination contract may have different (longer) repayment terms and interest rates.
- Consumers struggling to pay off large sums of money rarely qualify. Large amounts owed suppress credit scores. Late payments hurt them further.
- Approved borrowers usually increase their interest costs by lengthening the repayment period. The interest has more time to accrue.
- People can easily wind up in more trouble if they do not change behaviors. Credit card balances can quickly regrow if spending continues, or income drops.
How Debt Settlement Program Work
Debt settlement or relief programs work by consolidating payments into an escrow account. Once the person accumulates enough escrow money, the company attempts to negotiate a settlement with creditors.
The three primary benefits of a debt settlement program are that you can actually owe less money at the end of the process, it is much easier to qualify, and the impact on your credit score is meaningless.
- Settlement programs can reduce the amount of money owed in order to close out an obligation. Creditors may agree to stop all collection efforts in exchange for partial payment.
- People with bad credit readily qualify for a settlement program because the companies do not consider your FICO score. You simply need to owe more than $10,000 in unsecured obligations.
- The impact on your credit score is meaningless. Consumers who are currently behind on obligations already have very poor credentials and cannot borrow money anyway.
Time, delinquency, and uncertainty are the big drawbacks to debt settlement programs.
- It takes time, sufficient income, and sacrifice to accumulate enough money in an escrow account. Consumers have to delay gratification and change their habits in order to the process to succeed.
- Debtors purposely become delinquent on all their accounts. Creditors will not grant relief to people making payments on-time. Also, diverting the funds is necessary to build the escrow account.
- The process does not work for every person or situation. It can fail if you do not fund the escrow account. Creditors must agree to accept any proposed settlement.