Table of Contents
- Debt settlement companies can negotiate with your creditors to lower the amount of debt you owe them.
- Settling debt can relieve you of the financial stress that comes with being in debt, while also lowering the amount you need to pay back.
- Debt settlement comes with a variety of risks, like a drop in your credit score, the potential that it doesn’t work, and the need to stay diligent for up to several years.
- This process is a viable solution if you feel like bankruptcy is your only option, but it isn’t the first out you should consider.
Understanding Debt Settlement
Debt settlement is a process where a third party company negotiates with creditors to reduce the amount of debt owed. This process is also called debt relief or debt adjustment.
Once you’ve signed up with a debt settlement company, they’ll advise you to stop paying your creditors. In the meantime, you’ll need to save money in a separate account. The company will then use that saved amount to negotiate a lump-sum payment that’s less than the total amount owed.
Keep in mind that most debt settlement companies charge a fee. That said, they legally cannot accept payment until they’ve settled your debt.
Consumers can settle their debts on their own. If you lack the negotiation experience or commitment to driving a hard bargain, it may prove difficult to come to a satisfactory agreement with your creditors. The truth is, creditors want their money back, and they’re not afraid to pressure you until you crumble and pay them back.
Debt settlement is an option for those overwhelmed by debt, but it’s not without its drawbacks. Engaging a debt settlement company can be beneficial, especially for individuals who lack negotiation expertise. However, the decision to cease payments as part of the process could exacerbate financial difficulties. Be sure to weigh the immediate relief against the long-term impact on your credit score and financial standing.
How Debt Settlement Works
The general thought process behind debt settlement is that creditors want their funds back. When met with the choice to either receive a lower amount faster or wait years to receive the full amount, they may be apt to choose the former.
This allows debt settlement companies to serve as the negotiator between a consumer and a creditor. To start, the debt settlement company will require you to default, or stop making payments, on the debt you plan to negotiate.
Then, they’ll require you to make regular deposits into an account until there’s enough to make the negotiated lump-sum payment. Once it’s reached a substantial amount, they’ll reach out to your creditor and negotiate.
Keep in mind that this process can take years. It depends on how much you owe, how much you can afford to save, and what your creditor is open to accepting.
Benefits Of Debt Settlement
Debt settlement has its fair share of pros and cons. The pros are:
Reduced Debt
The primary benefit of debt settlement is the potential to reduce the total amount of debt owed. According to the American Fair Credit Council, the average settlement amount is 48% of the initial balance owed.
Avoiding Bankruptcy
Debt settlement is a viable alternative to declaring bankruptcy. Bankruptcy is a last-resort option because it remains on your credit report for 10 years, as opposed to the seven years a missed payment remains.
Creditor Relief
If you’re already missing payments on your debts, you may have received notices from your creditor. These can include calls, emails, texts, and even letters pestering you to pay back your debt, which can get annoying over time.
A successful settlement process, however, can get the creditor off your back.
While the prospect of reducing overall debt through settlement is appealing, it’s important to understand the full scope. Avoiding bankruptcy and gaining creditor relief are significant advantages. But, consumers must be mindful of the potential implications, including the impact on credit scores and the possibility of still facing aggressive creditor collection tactics. Each situation is unique, and what may be a relief for some might not be the most effective strategy for others.
Risks And Downsides
After reading the benefits, it might sound like mostly sunshine and rainbows. However, debt settlement has a variety of risks to be aware of:
Credit Impact
Withholding payments can lead to missed payments being reported to credit bureaus. This can damage your credit score significantly — like a drop of 100 or more points. These missed payments will remain on your credit report for seven years, so it won’t be something you can get rid of overnight.
Scams
Debt settlement scams are rampant despite legal action from the FTC. Oftentimes, these companies will charge a large upfront fee then abandon the consumer and never negotiate their debt. If you choose to pursue debt settlement, you’ll need to be incredibly careful which company you work with.
No Guarantee
There is no guarantee the debt settlement process works. Creditors may refuse to negotiate or reduce the amount you owe. In that case, you’ll be left with the same amount of debt you initially owed and a lower credit score than you had to begin with.
Tax Implications
According to the IRS, forgiven debt is taxable. This means that you’ll need to report how much of your debt was forgiven and plan to pay taxes on that amount.
Increased Debt
When you stop making payments on your debt, you’ll likely get hit with interest and late fees. This can cause your outstanding balance to increase rapidly. If the debt settlement process doesn’t work, you may be left with an even higher balance than you started with.
Length of the Program
The debt settlement process takes, on average, three to four years. This is a long time to miss payments and accrue late fees. This also means you’ll need the discipline and commitment to follow through with the process for an extended period of time.
The risks associated with debt settlement, such as credit damage, potential scams, and tax implications, should be considered. These factors could lead to greater financial strain than the original debt. Consumers considering debt settlement must be fully informed about these risks and explore all available options. It’s also smart to approach debt settlement with a clear understanding of the commitment required, as the process can be lengthy and requires strict financial discipline.
Alternatives To Debt Settlement
If debt settlement isn’t right for you, there are a few alternatives to consider:
Debt Management Plan
Nonprofit credit counseling agencies can help negotiate payment plans and lower interest rates. These services typically don’t require a fee, which differs from the debt settlement process. If you enlist a credit counseling agency to help you, use one of the approved agencies listed on the Department of Justice’s website to ensure they’re a reputable company.
Debt Consolidation
Debt consolidation is the process of combining multiple debts into a single loan with a lower interest rate. With a lower interest rate, you may be able to get ahead on payments, and you’ll save on interest over time.
The downside is that there might be upfront balance transfer fees or loan origination fees. Depending on the interest rate you get, it also might not make a significant difference financially.
Balance Transfer
A balance transfer is a credit card transaction in which debt is moved from one card to another card with a lower interest rate or a 0% interest introductory offer.
A balance transfer is an excellent way to get ahead on payments, especially if you land a 0% interest offer. That said, if you’re unable to pay off the debt before the 0% interest ends, you’ll wind up in the same situation you started in.
Self-Negotiation
You can try to negotiate settlements directly with creditors without involving third-party companies. However, this isn’t recommended unless you have the confidence and experience in negotiating a hard bargain.
Choosing A Debt Settlement Company
If you decide to pursue debt settlement, be careful about which company you choose to work with. Evaluate the company’s reputation, fees, and transparency carefully.
Reputation
Look for complaints with your state attorney general or local consumer protection agency to get a better idea of the company’s reputation. If the reviews look questionable, pick another company to work with.
Fees
Each debt settlement company will charge a different fee to work with them, although they typically range from 15% to 25% of the total debt the company is settling. For example, if you settle a balance of $20,000, the company would charge you anywhere from $3,000 to $5,000 in fees.
Transparency
The company you choose should provide clear information about the process, potential outcomes, and risks. If they seem to be avoiding questions, refusing to be upfront about the risks of debt settlement, or appear shady in any way, do not work with them.
Frequently Asked Questions (FAQs)
What Happens if I Do Debt Settlement?
If you decide to pursue debt settlement, you’ll stop making payments on your debts and store extra cash in a separate account instead. Once your savings reaches a solid point, the debt settlement company will negotiate a lump-sum payment with your creditor instead of the remaining balance you owe.
This will hurt your credit score, and there is no guarantee that the process works.
Does Settling Debt Hurt Your Credit?
Yes. Settling debt will hurt your credit score. It may drop by more than 100 points.
How Much Can You Usually Settle a Debt For?
According to the American Fair Credit Council, the average settlement amount is 48% of the initial balance owed.
For example, on a $30,000 balance, you’d likely pay $14,400 to the creditor once your debt is settled. Keep in mind that you’ll need to pay the debt settlement company for their service as well, which adds an additional 15% to 25% of the settled balance to what you pay.
In this scenario, you’d pay anywhere from $4,500 to $7,500 in fees to the debt settlement company. All in, this means you’re paying around $18,900 to $21,900 between paying back the creditor and settlement company fees. It’s important to evaluate whether the saving is worth it given the risks of debt settlement.
Who Qualifies For Debt Settlement?
Individuals with unsecured debt are eligible for debt settlement. This includes debt like credit card debt, personal loans, medical bills, and store credit cards.
Is It Worth It To Settle Debt?
Debt settlement is a risky process. It should be viewed as a last resort, or an alternative to filing for bankruptcy. You should pursue all other options before considering debt settlement.
Is It Better To Pay Off Or Settle A Debt?
It is better to pay off a debt in full than to pursue debt settlement.
