Debt Consolidation vs Debt Settlement: Know the difference

Obtaining a loan is simple, but effectively managing its repayment is difficult. Many times people avail a loan in a hurry to address an emergency. In such cases, they often end up getting stuck with a loan with high interest rates and unfavourable conditions. In such situations, higher interest rates are making your loan unaffordable. You have two options for dealing with this: debt consolidation or loan settlement. Both these strategies are far different from one another. Let's go over them in more detail.
 

What is Debt Consolidation?

 
Debt consolidation is a repayment strategy in which multiple loans are combined and repaid all at once with another financing product. The primary goal of debt consolidation is to reduce interest payments and improve credit scores through foreclosure.
 
Debt consolidation can be done for secured or unsecured financing. Most people prefer a personal loan for debt consolidation if their outstanding balances on their various debt products are low and they have a good credit history.

How does debt consolidation work?

 
Suppose you have the following outstanding debt to your name:
 

• Business term loan: Rs 23,50,000 at an interest rate of 16%
• Personal loan: Rs 3,50,000 at a 15% interest rate
• Unpaid credit card dues: Rs 2,00,000
• Used car loan: Rs 4,50,000 at 13%

 
You now need Rs 45,00,000 to fund your child's higher education while also paying off all previous debts at once. You own a commercial property worth Rs. 1,25,00,000. In this case, the best option is to obtain a mortgage loan against property, which is available up to a 75% LTV. It means you can borrow up to Rs 93,75,000 at a low rate of 10-12%. You can use this loan to pay off all of the above debts in a single EMI with a lower interest rate.
 
Also Read: Negotiating a Personal Loan Settlement: Here is What You Need to Know.
 

Benefits of debt consolidation

• You can easily get out of high-interest debts that you have acquired in the past.
• Debt consolidation entails the foreclosing of existing debts. It gives the lender the impression that you have a good repayment potential while improving your future borrowing capacity. 
• It helps you get an affordable loan in future.

 

What is debt settlement?

 
Debt settlement is a repayment strategy in which you pay off several or all of your debts at once for a much lower amount than you owe. Once you make a payment under this scheme, your credit report will show the status "settled." The need for debt settlement arises as a result of a sudden loss of income, a medical crisis, the death of the primary borrower, or other unforeseen events that impact repayment potential.
 

How does debt settlement work?

 
Assume you previously obtained a personal loan for Rs 3,00,000 with a 13% interest rate and a repayment term of 60 months. After paying EMIs for 36 months, you lost your job and requested a loan settlement.
 
The total debt paid to date, including interest payment, is Rs 2,86,704. The outstanding balance is Rs 1,91,136. If the lender agrees to debt settlement and is willing to close the loan after you pay Rs 50,000, the situation is referred to as debt settlement. The total loss to the lender, in this case, is Rs 1,41,136.
 

Benefits of debt settlement

 

• It assists you in reducing your overall debt burden while decreasing the debt-to-income ratio, which is a useful metric for loan approval.
• You can avoid a debt default situation and keep your credit score from deteriorating significantly.

 

What are the differences between Debt Consolidation and Debt Settlement?

 
You may have a sense of how these two repayment strategies differ. But let us differentiate using key points.
 

1. Impact on Credit Score

   The lender usually suffers a loss of interest income and the portion of funds disbursed in a debt settlement. Settlement may relieve the loan burden, but it has a significant negative impact on your credit score. In contrast, debt consolidation leads to credit build-up. By foreclosing on your existing debts ahead of their due date using a debt consolidation loan in India, you demonstrate responsible credit behaviour while also making repayment easier on your wallet.
    

2. Impact on Borrowing Potential

   By boosting your credit score, debt consolidation can help you improve your borrowing potential. If your credit is average, but you need a home loan in the next few years, this is one of your best options. On the other hand, debt settlement not just damages your credit report; it makes it difficult to obtain even a small loan in the future.
    

3. Suitability

   Debt consolidation loans are ideal if you have multiple high-interest loans and want to improve your credit score by foreclosing on most of your current debts. Whereas; you may seek settlement if you are in a financial crisis and the likelihood of bankruptcy is high.
    

4. Cost

   A debt consolidation loan may cost you higher due to a higher debt-to-income ratio. When it comes to debt settlement, your lender might not levy any additional charges considering your poor financial condition.
    

Also Read: Ways to Use a Personal Loan to Pay off Your Debt Faster
 

Conclusion

 
Debt consolidation and debt settlement serve distinct functions. The former helps you get out of high-interest debt while improving your credit score. The latter also lowers your EMI burden, but at the expense of a poor credit score. This influences your chances of getting a loan in the future. Instead of settling your debt, you should request a loan rescheduling and extend your repayment period.