If you're struggling with debt, you've most likely researched pay-off options. Two of the most popular ways to get rid of debt quickly are debt consolidation and settlement. But when it comes to settling debt, there are a few things you need to consider since both have very different outcomes.

What is debt consolidation?

Debt consolidation is when a person combines multiple debts into one large loan. This can save a lot of money since interest rates on debt consolidation loans are typically lower than the interest rates on individual debts. Debt consolidation can also help you lower your debt payments, which is especially important if you have high-interest debt.

What is debt settlement?

Debt settlement is when you negotiate with your lenders to lower the amount of money you are required to pay back. This can be a good option if you struggle to make your debt payments and would like to see them lowered. However, debt settlement can also have negative consequences, including increased interest rates and decreased credit ratings. 

Additionally, debt settlement can have unforeseen consequences when it's time to file your taxes. Since you used currency (credit) to purchase things but have not paid that back to your original creditor, the IRS will consider the balance of your settlement to be income. This can lead to significant penalties and tax bills, particularly if it puts you into a higher tax bracket.

When should you use debt consolidation vs. settling debt?

Debt consolidation is typically a better option than debt settlement if you have multiple creditors you need to pay off. Debt consolidation can lower your payments and potentially save you money in interest rates. If you're unsure whether it's worth it, consider using a debt consolidation calculator to crunch the numbers.

One drawback to debt consolidation is that it can temporarily cause your credit score to drop due to the hard pull on your credit report. However, the decrease in your credit utilization ratio should outweigh this temporary hit on your score. Most debt consolidation loans also require automatic payment withdrawals from your bank account. If you end up not being able to keep up with your payments, this could lead to additional debt, overdraft fees, and greater financial hardship.

Debt settlement, on the other hand, is a good solution when there's only one creditor you're in debt to and need to find a solution to your financial hardship. However, settlement can have negative consequences, including increased interest rates and decreased credit ratings. Additionally, debt settlement may have unforeseen tax consequences since the IRS counts it as income.

Are there other options besides debt consolidation and debt settlement?

There are a number of other options you can explore, such as working out a payment plan with your creditor, working with a credit counselor, or filing for Chapter 7 bankruptcy. You can also explore adding more income streams to your finances through side gigs or second jobs, adjusting your budget, cutting unnecessary expenses (even if only temporarily until your debt is paid off), or asking friends and family for help.

The bottom line

Debt consolidation can be an excellent option for some, while debt settlement is more practical for others. It's important to weigh all of the pros and cons before making a decision.