Liz Weston: What is the difference between debt settlement and debt consolidation services?

Dear Liz: There seems to be an abundance of companies offering debt reduction, settlement and consolidation programs now. Are there any differences in these programs? Some of these companies offer a program where high credit card balances and loans are combined and greatly reduced, and the debtor would make a single payment to said company. What are the advantages and disadvantages of this type of program? What would be the effect on the debtor’s credit history?

To respond: If a company promises to help you reduce the total amount you owe, this is called debt settlement. Typically, you stop paying your debts and make payments to the debt settlement company, which tries to broker a deal with your creditors.

Debt settlement can have a significant negative impact on your credit scores and you could be sued by unwilling creditors. The process can take several years and you may have to pay taxes on any forgiven debt, as this is considered taxable income for you. Once you add in the costs of the business, the amount you save from debt settlement may be less than you expected.

If you are considering debt settlement, first consult a bankruptcy lawyer (the Assoc. national consumer bankruptcy attorneys offers referrals), because bankruptcy is often a quicker, cheaper, and safer way to erase crippling debt. The most common type of bankruptcy, a Chapter 7 liquidation, typically takes three to four months, stops collection actions, legally erases many types of debt, and allows you to start rebuilding your credit immediately.

If a company promises to lend you money to pay off your loans and credit cards in full, this is called debt consolidation. Debt consolidation can make sense if you can get a lower interest rate than what you’re currently paying, the payments are affordable, and the loan gets you out of debt faster. However, you should be wary of debt consolidation companies that charge high upfront fees or charge high interest rates.

If you have bad credit, you’re probably better off consulting a nonprofit credit counseling agency than paying high rates for a debt consolidation loan.

Liz Weston, Certified Financial Planner, is a personal finance columnist for Nerd Wallet. Questions can be sent to him at 3940 Laurel Canyon, No. 238, Studio City, CA 91604, or by using the “contact” form at asklizweston.com.

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