Debt Relief Experts
Both debt consolidation and debt settlement can help you find relief from high interest credit card debt and accounts sent to debt collection, but the routes they take are very different. You can think of debt consolidation as a form of restructuring, while debt settlement is more like an escape route, a way to erase problem debt.
The truth is the right debt relief solution always depends on your circumstances. In this guide, I’ll provide a comprehensive comparison of debt consolidation vs debt settlement to help you determine which option is best for you.
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What are the differences between debt consolidation vs. debt settlement?
Debt consolidation is a process of transferring existing debts into one larger loan or repayment plan. There are several ways you can do this. You can get a personal loan through your bank, credit union or other financial institution. You can use a balance transfer credit card to move balances from your current credit cards to a new card with a lower interest rate. You can consolidate credit card debt and other bills into a second mortgage or home equity line of credit. You can also enroll in a debt consolidation program with a credit counselling agency, although a debt management plan is more of a repayment program than a consolidation loan.
As you can see, each of these options means moving debts around. No matter which approach you use, debt consolidation does not reduce your overall debt load. You still must pay back everything you owe.
In the case of debt settlement in Canada, a Licensed Insolvency Trustee works with you to present a proposal to your creditors to accept a lower payment and settle your account. This is a method typically used by Canadians who find themselves unable to make payments on their outstanding debt. The amount you pay back is reduced, with your settlement amount usually paid out monthly over up to five years.
Pros and cons of debt consolidation
Debt consolidation is appealing because it simplifies money management and can save you money.
Some key benefits of debt consolidation include:
- You simplify the way you pay your bills. You make a single payment to just one lender with one deadline every month instead of juggling multiple due dates to multiple creditors.
- You get a lower interest rate. Most consumer debts are the result of credit card bills with high interest rates. When looking for a debt consolidation loan, look for one with a lower interest rate. This way, you can get out of debt sooner because you are paying more towards principal with each payment and less in interest.
- Your monthly payment will be lower. In addition to a lower interest rate, you can choose to lengthen the term of the loan, which gives you more time to repay your debt and lowers your monthly payment. A lower payment can help you balance your budget so you can keep up with all your bill payments.
- It can increase your credit score. Even though debt consolidation solutions may hurt your credit score in the beginning, making timely payments will help you increase the score gradually. If you keep the old credit cards that you paid off through consolidation, your score will recover even quicker because this reduces your debt utilization ratio. Just remember to use the credit cards sparingly, so you don’t go back to square one.
Debt consolidation doesn’t come with advantages only, though. There are risks with a debt consolidation loan. By consolidating your existing debt, you are simply transferring all the debts you have into a new account that has an extended-term to pay it all off. This means that you can get in trouble if you miss making payments or continue to spend on your credit cards and rack up more debt.
Some disadvantages of debt consolidation include:
- The debt remains the same. Your total debt is not reduced or forgiven, so you’ll owe the same amount of money. The only difference is that you’ll only have one creditor. If you consolidate your debts but don’t decrease your spending, your financial situation will continue to deteriorate.
- You can’t consolidate effectively with a poor credit score. To qualify for a consolidation loan at a low interest rate, you will need to have a good credit score. If your credit is poor, your interest rate might be the same or higher, which gets you nowhere.
- If you don’t keep up with payments, creditors can sue to collect. If you default on your consolidation loan or balance transfer card, your creditors can take legal action against you, which may result in your wages being garnished and, if you have a secured loan you could lose your home or have your car repossessed.
Pros and cons of debt settlement
When you settle your debts, your creditors agree to accept less than you owe and forgive the remainder of your debts.
If you have decided that settling your debts is the right option for you, make sure you do it right. There are two ways to negotiate a debt settlement in Canada. One of them is via private debt settlement companies that offer debt settlement programs, and the other is by working with a Licensed Insolvency Trustee to file a consumer proposal.
Unlicensed debt settlement companies usually don’t work well, mostly because many creditors won’t negotiate with them. They often advise that you stop making payments towards your debts in the hope that you’ll eventually reach an agreement with your creditors. The danger of working with a for-profit debt settlement company is that your creditors won’t wait and will pursue you legally to collect. They can garnish your wages or freeze your bank account without the formal, legally binding creditor protection that a consumer proposal or bankruptcy can provide.
In Canada, the most common way to consolidate debts is through a consumer proposal filed with a Licensed Insolvency Trustee.
The main benefits of settling your debts with a consumer proposal include the following:
- You avoid bankruptcy
- You get protection against creditor actions
- Your monthly payment is much lower
- Payments are fixed, unlike in the case of bankruptcy
- You get to keep all your assets
The main disadvantage of any debt settlement program is that it does have a negative impact on your credit score. You will find it difficult to access credit for a while, although some people are able to get a new credit card within a year of filing.
Consumer proposals don’t affect any of your secured debt, such as your mortgage or car lease, which means that you’ll still need to make payments regularly to keep those assets.
To file for a consumer proposal, you need to make an appointment with a Licensed Insolvency Trustee, who will analyze your financial situation and discuss all available options with you. If you determine settling your debts through a consumer proposal is the best option for you, the trustee will help you prepare and file it for you.
Consumer proposals are legally binding debt settlement agreements. Once filed, you no longer need to deal with collection calls, and wage garnishments stop. All you unsecured creditors are bound by the same agreement, as long as the majority of your creditors agree to your terms.
Do debt consolidation loans hurt your credit score?
The answer is it depends. If you consistently make all your monthly payments on the debt consolidation loan on time, there should be no negative effects on your credit rating. Applying for a new loan may result in a short-term dip in your credit score. However, it will slowly go up again once you start making payments.
It is also possible for your credit score to improve. The reason is a debt consolidation loan can help you improve some of the factors that credit bureaus use to calculate your credit score.
A consolidation loan can help your score by:
- Improving your credit utilization as you move away from maxed-out credit cards. Of course, this is assuming you don’t drive up those balances again.
- Help you build a better payment history, especially if you previously made late or missed payments. Your old bad habits will age, have less impact on your score, and eventually fall off your report in six years.
- Improving the type of debt you have by converting revolving credit balances, like credit cards, to a term loan.
What is the effect of debt settlement on the credit score?
Debt settlement might be the best option financially if you’re struggling with debt, but your credit score will take a hit. How much of a decline depends on your situation going into the program.
If you are already behind on payments or have maxed out your credit cards, you already have a bad credit history and likely a low credit score to match. Even if your score is good, if you cannot afford to repay your debts, you risk defaulting on debts in the future. You may also not qualify for a debt consolidation loan, even with a good credit score, because you carry too much debt. Most lenders view having a high debt-to-income ratio is as bad as having a poor credit score.
You may be wondering why debt settlement should harm your credit score when your creditors are getting some of their money back, and you’re reducing your total debt. The answer is that credit scores reward accounts that have been paid according to the original credit agreement and on time before they’re closed. In the case of a debt settlement plan, the original agreement is modified when you agree to pay back a portion of the outstanding debts. As a result, credit bureaus modify your score downward while you are in a debt settlement program.
Having said that, creditors and the credit bureaus do look on programs like a consumer proposal better than a bankruptcy, where your debts are wiped out entirely. That is why debts in a consumer proposal are coded as an R7, while debts in a bankruptcy are coded as an R9.
Making a deal with your creditors is about getting rid of debt you can no longer repay.
You can begin to rebuild your credit history and show a new ability to handle debt wisely once your old debt is gone.
Should you use debt consolidation or debt settlement?
It is always better to pay all your debt in full if you can. However, life events happen – a job loss, income reduction, divorce, or illness – and these often lead to more debt than you can afford to repay. It is also true that a significant number of Canadians are living paycheque to paycheque, and just one sudden expense can mean more debt. When this is high-cost debt like a payday loan or high-interest instalment loan, this can create a cycle of debt that is hard to manage on your own.
Whether debt consolidation or debt settlement is a better solution for you depends on your finances.
Initially, you will want to see if you should get a debt consolidation loan.
To qualify for a debt consolidation loan, you must meet three basic lender requirements:
- You must have a reasonably good credit score – generally in the low- to mid-600s
- You must have sufficient income to support your loan payments
- You may need assets, such as some home equity, to provide as collateral
The higher your credit score, the lower your debt-to-income ratio and the more collateral you can provide, the lower your interest rate will be.
If you do not have any assets to get a secured consolidation loan, you can apply for an unsecured consolidation loan. These types of loans are considered higher risk and come with very high interest rates.
If your credit score is below 600, it is unlikely that you will qualify for a debt consolidation loan at any reasonable rate.
If you do not qualify or cannot afford a debt consolidation loan, your next option will be to consider making a proposal to your creditors.
Debt settlement or a consumer proposal is an option that is best suited to individuals who:
- cannot meet their current minimum debt payments as they come due
- do not qualify for a debt consolidation loan
- cannot afford to repay their debts in full
- have a minimum unsecured debt amount of $10,000 or more
- have enough income to pay back a portion of what they owe
The goal of debt settlement is to make your life easier by getting rid of some of your debt so you can balance your budget and stop relying on debt to survive.
Debt consolidation and debt settlement advice
Debt consolidation and debt settlement are both solutions that improve your financial situation by helping you deal with overwhelming debts, but they work in different ways. In summary, debt consolidation is useful for reducing the number of creditors you owe and lowering your monthly payment, while debt settlement works for those who want to reduce the total amount of debt they owe.
If you have a lot of debt and are looking at options to help you eliminate that debt, book a free consultation with a Licensed Insolvency Trustee. Our role is to help you review all debt relief options’ pros and cons and help you gain a fresh financial start.
