Dear Liz: There seems to be an abundance of companies offering debt reduction, debt settlement, and debt consolidation programs now. Are there any differences in these programs? Some of these companies offer a program in which high credit card balances and loans are combined and significantly reduced, and the debtor would make a one-time 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?
Reply: If a company promises to help reduce the total amount you owe, this is called debt settlement. Typically, you stop paying your debts and instead make payments to the debt settlement company, which tries to negotiate a deal with your creditors.
Settling debts can have a significant negative impact on your credit scores, and you could be sued by creditors who are unwilling to settle. The process can take several years, and you may need to pay taxes on any amount of debt forgiven, as this is considered taxable income for you. Once you add the business fees, the amount you save through debt settlement may be less than you expect.
If you are considering debt settlement, consult a bankruptcy lawyer first (the National Association of Bankruptcy Lawyers offers references), as bankruptcy is often a faster, cheaper, and safer way to erase a crushing debt. The most common type of bankruptcy, Chapter 7 liquidation, typically takes three or four months, stops collection actions, legally wipes out many types of debt, and allows you to start rebuilding your credit immediately.
If a business promises to lend you money to pay off your loans and credit cards in full, it’s called debt consolidation. Debt consolidation can make sense if you can get a lower interest rate than what you are currently paying, if the payments are affordable, and if the loan allows you to get out of debt faster. However, you should be wary of debt consolidation companies that charge large upfront fees or charge high interest rates.
If you have bad credit, you are probably better off going to 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 NerdWallet. Questions can be directed to him at 3940 Laurel Canyon, No. 238, Studio City, CA 91604, or by using the “contact” form at asklizweston.com.