With total household debt now nearing a record $14 trillion, many Americans are looking for better ways to manage their debt. While consumer debt is actually down (as a percent of GDP) compared to its peak, no one can argue that Americans don’t continue to carry extremely high levels of debt.

Americans Struggle with $1.5 trillion of Student Loan Debt

While overall debt levels have declined slightly, the types of debts Americans carry have shifted. Since the Great Recession, the share of household debt for mortgages has declined (along with the % of homeowners vs. renters), while debt for student loans and auto loans has increased. Not surprising, as student loan debt reached an unimaginable $1.5 trillion in 2020. Student debt is especially difficult as, in most cases, it can’t be discharged in bankruptcy.

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Why Americans Face More Debt than Ever

It’s not rocket science why Americans’ debt levels remain historically high, even after significant de-leveraging (banker-speak for foreclosures, defaults, and bankruptcies) during the Great Recession. The cost of basic elements of a middle class life – housing, healthcare, and education (college) – have increased dramatically, while income has stagnated. The middle class squeeze is very real. With incomes flat but costs rising, American families have increasingly gone into debt to access the traditional hallmarks of a middle class life.

While we encourage you to create a budget and generally avoid taking on debt if possible, we realize that’s easier said than done. If you’ve found yourself in a place where your debt feels unsustainable, you may be wondering about debt consolidation vs. debt settlement.

What is Debt Consolidation?

Debt consolidation most commonly refers to a debt consolidation loan. The basic idea is that you are taking out a new loan, and using the proceeds to pay off existing debts. A home equity line of credit (HELOC) is a popular option to do this. Because a HELOC is secured against an asset (your house), the interest rate tends to be low. However, the application process for a HELOC for debt consolidation may require an appraisal of your home and usually requires a stronger credit history than other products. Fewer banks have been offering HELOCs after getting burned by them in the 2008 crisis and, with the coronavirus-led recession, you may have trouble qualifying.

Personal loans for debt consolidation have been increasing in popularity as availability of HELOCs waned after 2008. It’s the same idea as using a HELOC, but instead of taking a line of credit against the equity in your home, a personal loan is unsecured — meaning that there is no collateral required.

What is the benefit to consolidating debts?

The primary benefit to using a loan to consolidate debt is to lower your interest rate. The most common debts borrowers consolidate are credit card debts – which carry high APRs. With the average APR for a HELOC around 5% and the average APR for a personal loan around 10%, this represents substantial savings vs. a typical credit card APR of 15-20%.

A second reason some consider debt consolidation loans is to lower their monthly payment. Compare your total interest costs under a debt consolidation loan vs. your existing debts carefully — while a lower payment may be appealing, this is often achieved by lengthening the term of the loan. This makes monthly payments smaller, but means you’ll pay more in interest over the life of the loan.

Additional benefits may include a single monthly payment (if you consolidate ALL of your other debts) and, possibly a higher credit score, if you are paying down credit card debt.

Should you use a debt consolidation loan?

There are too many individual factors for us to give you a definite recommendation (we are working on a guide for this!). Using a debt consolidation loan can make sense – especially if you’re lowering your interest rate – but we encourage caution. Many borrowers who consolidate debt from credit cards end up right back where they started within 12-18 months.

Bottom line: if you use a debt consolidation loan, we recommend cutting up (or closing altogether) credit cards to avoid the temptation to get back into debt. If you’re consistently spending more than you earn month after month, take a hard look at your budget and make the tough cuts where necessary.

What is Debt Settlement?

The debt settlement (and its cousin, credit repair) industry is one of the less reputable corners of the consumer finance world. Most debt settlement companies work something like this:

  • Create a debt settlement “plan”
  • Tell you to stop paying your creditors (overdue bills, credit card companies, etc.)
    • these non-payments WILL be reported to the credit bureaus, hurting your credit score
  • Instead, ask you to send a payment to the debt settlement company
  • Ask you to delegate communication with your creditors to them
  • Attempt to negotiate a settlement on your behalf, where less than the outstanding balance is paid to settle the debt
    • If a settlement offer IS excepted, it is reflected on the credit bureau as a “Settled” account, and will impact your credit score
  • Use the funds you’ve been paying the debt settlement company to pay the creditors, keeping a fee for itself
    • If what you’ve paid isn’t enough to cover your settlements, you will still owe more to the creditors

Should You Use a Debt Settlement Service?

If you’re to the point where you are in debt and cannot keep up with your monthly payments, rather than engage a debt settlement firm, we suggest contacting your creditors directly. They may be willing to work with you by creating a payment plan, freezing or reducing interest, or offer you a settlement directly. Yes, this is more time consuming, but you’ll likely get a better outcome, and it will cost you less.

If after contacting creditors (or debt settlement, if you go that route) your monthly payments are still unaffordable, it’s time to consider bankruptcy.

More to Come

More to come on debt consolidation, debt settlement, and bankruptcy in future Bank Insider Guides.

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photo: Ian Espinoza on Unsplash