What's the difference between debt consolidation and debt settlement?

Debt consolidation and debt settlement are both financial strategies for improving personal debt load, but they function quite differently and are used to resolve different issues. At a very basic level, debt settlement is useful for reducing the total amount of debt owed, while debt consolidation is useful for reducing the total number of creditors you owe. It is possible to receive secondary benefits through either strategy, particularly debt consolidation.

You consolidate your debts through a consolidation loan, which is a single loan that combines and replaces all of your prior debts into one monthly payment with one interest rate. Consolidation loans are offered through financial institutions, usually banks or credit unions, and all of your debt payments are made to the new lender.

For some, the psychological benefits of having a simplified, consistent monthly payment are enough to warrant a debt consolidation strategy. In some circumstances, a consolidation loan might result in a lower total monthly payment or a lower average interest rate on your debt. Unfortunately, this savings can be offset through extended repayment terms, so be sure to consider the long-term costs of consolidation loans.

Most consolidation loans are secured with one of your assets, such as your home, car, retirement account or insurance policy. Only accept a secured consolidation loan if you are comfortable with putting up considerable collateral. (For related reading, see "Debt Consolidation: When It Helps, When It Doesn't.")

A debt settlement strategy does not seek to replace existing debt with a new loan, as consolidation does. Instead, debt settlement is a series of negotiations between your creditors and you (or a credit counselor) to make pay less than you currently owe, usually in a lump-sum payment.

Creditors are under no obligation to enter negotiations or accept your offer. Nevertheless, it is often possible to pay much less than you currently owe if the creditor believes your offer represents the creditor's best chance to recoup at least a portion of the loan. Advanced debt collection techniques and accounts receivable processes can be expensive, and fighting through a bankruptcy proceeding is unattractive to most lenders. The process is not usually completed after one round of communication; in fact, stretching out the debt settlement process is a common strategy to force a creditor's hand. (For related reading, see "Negotiating a Debt Settlement.")

Settled debt is gone – wiped clean. However, with unsecured debts such as credit cards, you risk having your account closed completely after the settlement is complete because the lender will not want to continue to grant you credit. Contact the Federal Trade Commission (FTC) or the National Consumer Law Center for free information on debt negotiation and debt negotiators.

Either strategy can have lasting impacts on your credit score, so be sure to weigh the pros and cons carefully before undertaking debt consolidation or debt settlement. (For related reading, see "Debt Settlement Arrangements and Your Credit Score.")