Debt Settlement vs. Debt Consolidation: 5 Questions That Reveal the Difference

When you settle debt, you cut a deal with the funder to resolve the obligation. When you consolidate debt, you get new financing to pay off specific advances. Settling debt ends your obligation in a way that a funder agrees to, while consolidating it replaces it with another debt. Here are five questions to ask to know which one fits.

Neither option is one single product that applies to every debt and creditor; each comes in lots of different forms, with its own advantages and disadvantages. Reducing the daily withdrawal can ease the cash flow burden, but may not resolve the debt in full or eliminate your guarantee of it.

The first question: once you settle a debt, confirm what that settles. Did the funder give you a written release? What are the exact names of the funders, agreements, entities, and guarantors it covers? One funder’s deal to settle an obligation doesn’t settle the others. Also look at what the settlement releases. A settlement agreement that pays the funder what you can afford is great - but how does it resolve pending lawsuits, pending motions, and ongoing disputes, if any? What remains unresolved is just as important as what gets settled.

If you want to consolidate debt, make sure the new debt ends the old. A true consolidation pays off named advances. A reverse consolidation may pay for your existing financial obligations while leaving them open. Before signing, find out which obligations your consolidation is ending and which are staying in place. Make sure to get payoff amounts for each debt your consolidation is handling. Also check how remaining balances, old debt guarantees, and old obligations get treated.

Total Repayment

The second question to ask about debt consolidation or settlement is: will you owe less? Getting a smaller payment does not mean you’re paying less. Compare the payoff amount, fees, and total repayment. Sometimes, the new funder is proposing a longer time. Watch for when a “lower” loan payment is just adding fees, or adding debt guarantees. Check all those changes before accepting a proposal, and make sure it leaves enough cash left to carry on.

Before settling a debt, also know what tax you’re agreeing to pay and what the funder is going to report. If the funder cuts or cancels all or part of the debt, how will they report it? A lender that cancels $600 or more files Form 1099-C. You do not have to treat debt settlement or forgiveness as income to the extent you were insolvent beforehand. Even if you don’t have to pay taxes on a particular 1099-C, you may still have to file Form 982 with your tax return. To determine whether you were insolvent or not, look at the value of all your liabilities just before the cancellation of debt, and compare them to the fair market value of your assets at that point. If your liabilities exceeded the value of your assets, you were insolvent. It’s important to consult a professional with this.

Qualify for New Financing

Now comes the third question: Do you have the financial credentials to qualify for new financing? The SBA 7(a) loan program allows some businesses to refinance business debt, up to $5 million. One thing to understand is that to get an SBA 7(a), you must show that the business can’t get the necessary funding elsewhere on reasonable terms. An SBA rule that says MCAs may not be refinanced is set out in the SOP at 50 10 8. You’ll want to check beforehand whether SBA would allow you to borrow the funds to refinance your merchant cash advance. As a practical matter, there’s no way to consolidate debt without new financing. If the business doesn’t qualify, settlement may be an option.

What Happens While You’re Waiting

Before settling debt, ask what happens while you’re waiting. Usually, the answer is that you stop paying the funders, and your fees keep mounting up. Credit reports and scores suffer. Your funder can sue. As a rule, a delinquent debt can stay on your credit report for up to seven years. Before stopping electronic debits or changing bank accounts, get legal advice.

The fifth question: make sure you know what stays on you. If you signed a personal guaranty, the creditor can reach your personal assets if the business defaults. Does the release let you off? Do you still have personal collateral pledged? Any open UCCs? Is a new funder replacing your loan, or just piggybacking onto it? Will it file new UCC financing statements? Ask what happens if you miss a payment. Who will handle an existing or future lawsuit?

If a lawsuit is pending, or a deposit account has been seized, don’t assume settlement talks extend the deadlines or release the funds. If you are served with a summons and complaint, save a copy of the summons, complaint, and anything that was attached. Before you throw away that envelope, confirm with an attorney what each item is, how and where it was served, and who’s named in it.

A settlement firm, funder or lawyer cannot promise that all of your creditors will agree. If part of an insolvency, ask a bankruptcy lawyer whether a Chapter 11 review is appropriate.

The next step is to make a cash-flow map. Put in each week’s payroll, rent, tax deposits, and supplier bills. Put in the current debt service. Now overlay each refinance or settlement option against that. Ask, “What will happen if we can’t make these payments?”, not just, “What is the monthly payment?” Before you decide to settle, compare the money, conditions, and timelines to those of consolidation or refinance. Read the agreements and understand what each one means.