Debt Consolidation VS Debt Settlement
Today I am going to explain the difference between debt consolidation and debt settlement.
“Debt Consolidation” as defined by Wikipedia: The combining of several unsecured debts into a single, new loan that is more favorable. Debt consolidation involves taking out a new loan to pay off a number of other debts. The new loan may result in a lower interest rate, lower monthly payment or both.
A debt consolidation occurs when you are able to consolidate numerous debts into one monthly payment. This is an example of how that typically works: you have 3 credit cards, a small personal loan, an overdraft and perhaps a line of credit which total $40,000.
So as it currently sits you have up to six separate payments to make each month totaling $1200 with varying interest rates (cost of borrowing) for each one. This is often a strain on a person’s cash flow and typically most of that $1200 is interest. I call this bad debt.
To consolidate this debt you would contact your bank and ask for a consolidation loan. If the bank deems you to be a worthy borrower they will combine the 6 current debts into one loan usually at a significantly lower interest rate. As such you now have a loan for the total debt amount, $40,000, and you would now have one monthly payment of $811 (assuming 8% interest and a 5 year term) instead of the six payments totaling $1200.
That payment is almost $400/month lower than the six combined and now you are paying off a good portion of principle along with the interest. This is good debt compared to where you were. There are variations of this; sometimes that consolidation can be done as a second mortgage which is utilizing some of your home equity or it could be done as a credit line. Doing a debt consolidation does not typically have a negative effect on your credit score.
“Debt settlement” definition by Wikipedia: Debt settlement, also known as debt arbitration, debt negotiation or credit settlement, is an approach to debt reduction in which the debtor and creditor agree on a reduced balance that will be regarded as payment in full.
A debt settlement is usually something people turn to when the bank turns them down for debt consolidation. A debt settlement means that the goal is to once again turn numerous monthly payments for various debts into one monthly payment. The difference being that the debts are being settled in the debt settlement.
Using the same example as above you have $40,000 of debt between credit cards and a line of credit and $1200/month in payments. The debt settlement could reduce the overall debt down to $12,000 (results will vary). So now you would have a new agreement in place with your creditors to pay off $12,000. Note this is an agreement, not a loan.
If this is done formally through a consumer proposal for example, you would make one monthly payment of $200 for 60 months for all of the debts and it would be interest free. This reduces your monthly outlay by $1000/mth! I’m sure this sounds great but keep in mind that although the above example is a great settlement it will vary according to circumstances. It will also have a negative effect on your credit score.
However, if the bank has already turned you down your credit score isn’t doing you any good anyway.
So to summarize debt consolidation is a very effective way to deal with debt if your credit score is sufficient, your income can support the loan and the bank deems you to be a good risk. Also look at your budget to make sure the new consolidated payment is manageable.
The debt settlement option is something you need to consider if your current monthly payments are overwhelming and the bank has turned you down for a consolidation loan.
I have helped close to a thousand individuals and families with debt settlement plan and debt consolidation. If you have questions or want to find out what is best for you or what kind of settlement I could help achieve for you please give me a call at 905-243-8765.
About the Author:
Trevor Glasser owns the 4 Pillars Consulting Oshawa, On Office helping people get out of debt every day. If you need a free consultation to understand your options please feel free to contact Trevor at 905-243-8765 or www.goodbyedebt.ca.