Entrepreneurs in need of funds to run their business can turn to a variety of financing options. But loans and other forms of access to capital can be a double-edged sword: some business owners tend to overborrow. Is that your case and you are finding it difficult to meet your repayment obligations? If you face this issue, debt consolidation or debt settlement could provide a solution.
While the two sound similar, they are very different approaches to solving the problem of taking on too much debt.
In this post, we’ll describe what debt consolidation and debt settlement mean, the merits and demerits of each of these methods, and the best way to choose between them.
Debt Settlement: How Does It Work?
The term debt settlement can be deceptive. When you think of “settlement,” it conjures up an image of two parties amicably agreeing to something. The impression created is that both the lender and borrower benefit.
However, the truth is a little different.
First, let’s understand what the term means. Debt settlement involves the creditor agreeing to close the account for an amount that is less than the total sum that is due. In other words, the borrower could pay a sum that is lower than what is owed. The lender would not ask for the remaining money. No more collection calls and threats of court notices.
The process works in this manner. You stop paying the lenders. After the debt has piled up to a significant amount, you offer to settle it by paying 75% or even less of the amount that is due. Many borrowers use the services of a professional debt settlement company. This organization negotiates on your behalf (for a fee) and gets the best possible deal for you.
If you think debt settlement sounds too good to be true, you’re right.
This method of paying off creditors can often be a poor option, and its repercussions could be harmful to the borrower who has settled the debt. Here are its main drawbacks:
- It can play havoc with your credit score. If you engage the services of a debt settlement company, the money you pay could go into an escrow account. Payment to the lender would be made only when a settlement is arrived at. In the meantime, the fees for late payment and other charges continue to accumulate. This has a negative effect on your credit.
- Debt settlement negotiations could fail. If this happens, you would be worse off than when you started.
- The debt settlement company’s fees eat into the amount you have saved. The fees could be as high as 20% or more of the total debt you start with.
- If the lender cancels debt over $600, it’s considered to be taxable income that you would need to report on your tax return.
Does this mean debt settlement isn’t a good option? If you have borrowed too much and are looking for a way out, it could offer an escape. Here is a summary of the pros and cons of debt settlement:
Pros and cons of debt settlement
|1. It allows you to settle your debts for a lower sum than is due.||
|2. It could save you from bankruptcy.||
3. Settling your debts will stop collection calls and lawsuits.
4. Instead of constantly worrying about your debts, you could start focusing on your work.
|4. Debt settlement companies can be expensive.|
Debt Consolidation: How Does It work?
Debt consolidation could be a far better way to pay off your loans. Here’s how debt consolidation works.
A small business owner may have multiple loans from several different lenders. You could owe money to an online lender and have borrowed from your bank, as well. Additionally, you could have a substantial amount outstanding against your credit card.
If you owe money to five or six lenders and have to make a monthly payment to each of them, the process of keeping track of all of them could be cumbersome. A debt consolidation loan could offer a solution.
A debt consolidation loan involves taking a new loan to pay off all your existing debt. If you opt for a debt consolidation loan, you won’t have to make several payments every month. Instead, a single payment to the new lender will suffice.
Camino Financial offers small business loans to entrepreneurs who need funds for buying capital equipment or paying business-related expenses. You can also use a business loan from Camino Financial as a debt consolidation loan. Our motto is “No business left behind.” Our loan specialists will do their best to provide you with the money you need for your company.
Is it a good idea to opt for a debt consolidation loan? You’ll be in a better position to decide after considering the pros and cons of this form of debt management.
Pros and cons of debt consolidation
|1. Convenience – if you opt for debt consolidation, you won’t have to struggle with multiple payments to different lenders. A single payment to your new lender will take care of your repayment obligation.||1. More interest payments in the long run – if your new payment schedule is significantly longer than the repayment terms of your previous debts, you could pay far more in interest costs.|
|2. Savings on interest costs – the new loan you take could carry a rate of interest that is lower than the rate on your existing loans.||
2. Need to provide collateral – some lenders insist on security when providing a consolidation loan. If you pledge your car or your home and subsequently fail to repay the loan, there is a possibility your personal assets could be seized by the lender.
3. More time to repay – your new loan could have an extended repayment term. This could result in a lower monthly installment payment amount.
|3. Unsecured consolidation loans aren’t easy to find – identifying a lender that offers unsecured consolidation loans could be difficult.|
4. A positive effect on your credit score – if you have multiple debts, there is a greater chance of missing a repayment and damaging your credit. Consolidating your debt into a single loan could ensure that you never miss a payment.
|4. Upfront costs may be high – your new consolidation loan may carry an origination fee. If it does, this is an additional cost that you would have to bear.|
Debt settlement vs. Debt consolidation: Which One Is for You?
It can be difficult to decide between debt settlement and debt consolidation. In some respects, the two methods of debt management are similar. Both give you a chance to start off with a clean slate.
However, in most other ways, they are dissimilar. Which should you choose? Taking the following steps could help you make the right decision.
1. Calculate your debt to income ratio
It could be useful to calculate your debt to income ratio. This tells you the percentage of your total monthly income that goes towards your monthly debt payments. A high percentage, say, 50%, could indicate that you are carrying too much debt. If your debt to income ratio is high, and you are continually running short of cash, debt settlement may be a good option.
2. Compare how debt consolidation and debt settlement would work in your situation
Compare debt consolidation and debt settlement carefully and understand the implications of each. Here’s a table that summarizes the attributes of both.
Debt consolidation and debt settlement – a comparison
|Debt consolidation||Debt settlement|
|Does it reduce your total debt?||Typically, it doesn’t reduce your total debt. But in some instances, it could.||Yes, it could. In fact, the idea behind settling your debt is to pay a lower amount than is due.|
|Does it reduce your interest cost?||It depends on the terms and conditions of your new loan. For example, if a small business loan from Camino Financial is used to consolidate your debt, it could result in lower interest costs.||Yes, it could. When you settle your debt, the lenders could agree to reduce the interest.|
|What’s the impact on your credit score?||Debt consolidation could have a positive effect on your credit score. However, this is not true in every instance of debt consolidation.||Your credit score could take a hit. The fact that you have settled your debt will remain on your credit report for seven years.|
|Does it involve negotiating with the lenders?||No. You would pay off your old debts with the new loan.||Yes, extensive negotiations could be involved. Sometimes negotiations break down, and the borrower is left worse off than before.|
3. Ask yourself some key questions
Answering these questions may help you decide between debt consolidation and debt settlement:
- Do you have multiple loans? Do you find it difficult to keep track of repayments? Would you like to lower your interest costs or extend your repayment period? If your answer to these questions is yes, debt consolidation may be a good idea.
- Have you taken on too much debt? Are you unable to meet even the minimum payment on your credit card balances? Is bankruptcy a possibility? If this describes your financial situation, it may be time to start looking around for debt settlement options.
The Bottom Line
Both debt consolidation and debt settlement can have long-term implications. Before adopting one of these debt management strategies, you should think about the consequences carefully. This is especially true about debt settlement. Remember that settling your debt could result in the settled account remaining on your credit report for seven years.
For most small business owners, debt consolidation could be a better option. We invite you to read our post Debt Consolidation Loans: A Complete Guide for more information on this subject.