Consolidation Loan, Counseling, Settlement or Bankruptcy: How to Choose

Debt settlement and debt consolidation get compared as though they were rival brands of the same thing. They aren’t. A consolidation loan rearranges debt you intend to repay in full. Credit counseling with a debt management plan also repays it in full, at better terms. Debt settlement tries to pay less than you owe. Bankruptcy uses the courts to reorganize or wipe out debt. Each fits a different level of trouble, and each has costs the advertising tends to skip.

This guide lays out all four fairly, then matches them to situations. One step comes before all of them: call your creditors. Many card issuers and lenders have hardship programs that can lower a rate or pause payments for a while, and asking costs nothing. Get any arrangement in writing.

The four options at a glance

Option 1: a consolidation loan

You take a new installment loan, use it to pay off cards or other debts, and repay the loan on a fixed schedule. It helps when the loan’s APR, including any fee, is clearly lower than what you pay now and the term isn’t much longer. It doesn’t reduce what you owe; it only changes the price of carrying it.

Fits: people whose income comfortably covers the debt payments, whose credit still earns a reasonable rate, and who mainly want a lower rate and a fixed end date.

Doesn’t fit: people who are already missing payments, or whose credit only qualifies them for rates near what the cards charge. We work through when consolidation saves money, and when it quietly costs more, in three worked cases.

Option 2: nonprofit credit counseling and a debt management plan

Credit counseling starts with a review of your income, expenses and debts with a counselor. Sometimes that session is all you need: a budget, a priority list, or confirmation that you can handle things yourself. If not, the counselor may propose a debt management plan, or DMP.

Under a DMP, the counseling agency works with your creditors to lower interest rates or waive certain fees. You make one monthly deposit to the agency, and it pays your unsecured creditors, such as credit cards and some medical bills. According to the FTC, these plans often take 48 months or more to complete, and they don’t cover secured debts like a mortgage or car loan.

• Cost: agencies may charge a setup fee and a monthly fee; some states cap these. Nonprofit status doesn’t automatically mean free, so ask for fees in writing.
• Credit: creditors commonly require the enrolled cards to be closed, and you’ll usually agree not to open new credit during the plan. Paying on time through the plan avoids the damage of missed payments.
• Not a loan: a DMP doesn’t require a credit approval, which makes it reachable for people who can’t qualify for a decent consolidation loan.

Fits: people who can afford to repay what they owe if the interest rates come down, and who would rather not borrow again.

Option 3: debt settlement

Debt settlement companies try to get your creditors to accept less than the full balance. The usual model: you stop paying the enrolled creditors and instead deposit money each month into a dedicated savings account. Once enough builds up, the company offers a lump sum to one creditor at a time.

How settlement companies get paid

Fees are typically a percentage of the debt you enroll or a percentage of the amount the company saves you. For debt relief sold over the phone, including when you call a number from an ad, the FTC’s Telemarketing Sales Rule says the company can’t collect any fee until it has settled or changed at least one of your debts, you’ve agreed to the deal, and you’ve made at least one payment under it. The fee has to be proportional to the debts actually resolved or based on the savings. Sales made entirely face to face can fall outside that rule, so ask exactly when and how fees are charged regardless.

Any dedicated account must be held at an insured financial institution, and the money in it is yours: you can generally withdraw it and leave the program at any time.

The risks

• Your credit takes heavy damage. Months of missed payments are reported, and accounts may be charged off. The CFPB warns settlement can leave some people deeper in debt than when they started.
• Balances grow while you save. Late fees and penalty interest keep accruing on accounts you’ve stopped paying.
• Creditors don’t have to agree. Some won’t negotiate with settlement companies, and few programs settle every debt.
• You can be sued. A creditor or debt buyer may sue while you’re saving. A court judgment can lead to wage garnishment or a lien, depending on state law.
• Forgiven debt may be taxed. The IRS generally treats canceled debt as income. A creditor that cancels $600 or more is generally required to send Form 1099-C.

On the tax point: if you were insolvent when the debt was canceled, meaning your total debts exceeded the fair market value of your total assets, some or all of the canceled amount may be excluded. That is claimed on IRS Form 982 and explained in Publication 4681. A tax professional or a free IRS-sponsored tax clinic can help.

Fits, sometimes: people who are already far behind, can’t afford a DMP, have a realistic way to build lump sums, and want to avoid bankruptcy. Even then, compare it with a bankruptcy consultation before enrolling.

Option 4: talk to a bankruptcy attorney

Bankruptcy is a federal court process. In broad terms, Chapter 7 can discharge many unsecured debts after any non-exempt assets are sold, and Chapter 13 sets up a court-approved repayment plan, usually over three to five years, that can let you keep property such as a home. Filing generally triggers an automatic stay that halts most collection activity, including lawsuits and garnishments. Some debts, such as most student loans, recent taxes and child support, are usually not discharged.

The costs are real: attorney and court fees, a bankruptcy entry that can stay on credit reports for up to 10 years, and a public record. But for someone with debts they cannot realistically repay, a consultation can show that bankruptcy would resolve things faster and with less total damage than years in a settlement program. Many bankruptcy attorneys offer a free or low-cost first consultation, and legal aid organizations help people with low incomes.

Before filing, individuals must complete credit counseling from an agency approved by the U.S. Trustee Program within 180 days. The Department of Justice list of approved agencies is for that specific requirement; it isn’t a general endorsement of those agencies’ other services.

Matching the option to your situation

Finding a legitimate counselor

Start with the two national associations of nonprofit credit counseling agencies: the National Foundation for Credit Counseling (NFCC) and the Financial Counseling Association of America (FCAA). Both let you find a member agency, and many agencies counsel by phone or online. Your state attorney general’s office can tell you whether complaints have been filed against a company.

The FTC’s advice is worth repeating: if a counselor says a debt management plan is your only option before reviewing your finances, find a different counselor.

Red flags with any debt relief offer

• Fees before results. Charging before settling any debt is prohibited for telemarketed debt relief.
• Guarantees. No one can promise how much a creditor will accept or that collection calls will stop.
• “New government program.” There is no federal program that forgives ordinary credit card debt.
• “Stop talking to your creditors.” You lose track of what’s happening to your accounts.
• A “consolidation” pitch that turns out to be settlement. The CFPB warns that some companies advertising consolidation are actually settlement firms.

For more warning signs, see our guide to loan scam warning signs.

If you only do one thing this week, book a free session with an NFCC or FCAA member agency. Even if you end up choosing a loan, settlement or bankruptcy, you’ll be choosing with a full budget in front of you rather than an ad.