Debt Settlement
Debt settlement refers to the negotiation by a third party with your creditors to dramatically bring down your debt and reduce the balance by a large percentage. The third party negotiates with the creditor by using a lump sum as leverage to pay off the balance.
Here’s an example: Suppose a person owes his creditor $10,000. The debt relief company will ask the creditor to consider “forgiving” 60% of what the debtor owes. If the creditor agrees, it receives the 40% immediately and the rest of the debt is cancelled out. The debtor goes away with a clear record and the third party gets paid a fee that they and the debtor initially agreed upon.
Many people don’t know this is an option and although it might seem too good to be true, there are thousands of examples of this type of success. Sometimes, creditors might doubt the debtor’s ability to pay the total amount and decide to get back as much as it can in a short amount of time. However, there are also cases when the creditor would much rather let the debt remain and take its chances on having the debtor pay for what he owes plus interest based on their original agreement.
In order to pay this lump sum, the debtor agrees to save up by depositing a fixed amount into a savings account each month. When he has saved enough in this account, the debt settlement company contacts the lender and negotiates on the debtor’s behalf. Once the creditor agrees to the payment, the original amount owed is reduced and the debt will be paid off.
How Does Debt Settlement Work?
Private debt settlement companies are for-profit businesses that charge a fee of 15%-25% of the original debt or the reduced settlement amount.
When you enter into an agreement with a debt settlement company, you will be instructed to stop making payments to your creditors. Instead, you’ll make payments to the settlement company, which are deposited into an escrow account along with their fees. During this time, the company will negotiate with your creditors to reduce the total debt. Once the agreed-upon amount is reached in the escrow account, the company will pay your creditor. This process can take 24-36 months.
Debts That Can Be Settled Through Debt Settlement
Most unsecured debts qualify for debt settlement, but only if the creditor agrees. The creditor is not obligated to accept any settlement offer.
Unsecured debt includes items like credit card balances, store cards, personal loans, and medical bills—essentially any debt not linked to property the creditor can reclaim.
Generally, the following types of debt are not eligible for settlement:
- Secured debts, such as mortgages or car loans
- Student loans
- Business-related debt or debt from self-employment
- Tax debt
Before signing an agreement with a debt settlement company, ensure that the debt you wish to settle is eligible by checking resources from the Federal Trade Commission, the Consumer Financial Protection Bureau, or your state’s attorney general.
Is Debt Settlement a Good Option?
Although debt settlement has its disadvantages, it can be a viable debt relief solution in certain financial situations. For example, individuals who owe a significant amount to a single creditor might find it helpful. If a creditor is willing to accept half of what you owe to settle a debt that would otherwise be unmanageable, it could be a worthwhile option.
However, it’s crucial to carefully evaluate the benefits and drawbacks of debt settlement in relation to your specific circumstances before committing to an agreement.
Benefits of Debt Settlement
Debt settlement offers several potential advantages, including:
- A reduction in the amount owed, sometimes as much as 50%
- An alternative to bankruptcy for those able to pay the settlement amount
- Relief from debt collectors or collection agencies once the debt is settled
Risks of Debt Settlement
While debt settlement can be helpful, there are a few factors to keep in mind:
- Fees: Many debt settlement companies charge fees, which are only collected once a settlement is reached. These fees are separate from your debt and do not contribute toward reducing the amount you owe. When factoring in fees and additional interest, the overall savings from debt settlement may be lower than expected.
- Impact on Credit Score: The effect on your credit score can vary depending on your situation. If your account is already in default or past due, your credit score may have already taken a hit. However, settling the debt could cause a further decrease, potentially by 100 points or more. Additionally, the settled account will remain on your credit report for up to seven years from the date of the first missed payment, which could make it more challenging to secure loans in the future, particularly if you’re considering purchasing a home.
- Tax Consequences: When a creditor agrees to settle your debt for less than the full amount, the forgiven portion may be considered taxable income by the IRS.
Why Choose a Debt Settlement Company?
There are times when a person’s debt becomes unmanageable and impossible to pay off. Often, this occurs due to circumstances like a job loss, a pay cut, significant medical expenses, or an unexpected emergency. Regardless of the reason, it can be incredibly challenging to escape overwhelming debt on your own. This is especially true for credit card or other revolving debts, which seem to persist despite regular monthly payments.
Debt settlement may provide a potential solution, but, as mentioned above, it requires careful consideration. A debt settlement company can negotiate with your creditors to accept less than what you owe. However, this option must be approached with caution, as working with a debt settlement company may not resolve your issues and could even worsen your financial situation.
Beware of Debt Settlement Scams
It’s easy for someone struggling with debt to fall victim to a debt settlement scam. While the industry is regulated to protect consumers, recognizing scams is simple if you know what to watch out for.
The Federal Trade Commission advises those seeking debt relief to avoid the following:
- Companies that promise to settle credit card debt for less than what you owe, or for “pennies on the dollar” (since creditors are not required to work with debt settlement companies, no company can guarantee this).
- Companies that demand fees upfront before resolving your debt.
- Companies that fail to explain the risks of their programs, such as the high rate of consumers who drop out without settling their debts.
- Companies promoting a “new government program” to erase personal credit card debt.
- Companies that guarantee to eliminate your unsecured debt.
- Companies advising you to stop communicating with creditors without warning you of the serious consequences.
- Companies claiming they can stop all debt collection calls and lawsuits.
The best way to avoid scams is to stay informed. Check the FTC website, your state attorney general’s office, or your local consumer protection agency to learn the rules governing debt settlement companies. These organizations not only outline what these companies can and can’t do, but they also provide lists of companies with consumer complaints. You can also inquire with your state’s attorney general about whether a company is licensed to operate in your state. Additionally, a quick search of the company’s name along with the words “complaints” or “scam” can provide valuable insights.
Debt Settlement Companies: Hidden Fees and Tax Risks
While there are trustworthy debt settlement companies, others are not. To protect consumers, these companies must follow specific regulations. Though they may not mention risks like tax implications or credit score damage, they are required to disclose certain information.
Disclosure Requirements for Debt Settlement Companies
Debt settlement companies are required to disclose certain information before you sign up, which can help you determine if debt settlement is right for you. These disclosures include:
- A clear explanation of pricing, terms, fees, and any service conditions.
- The estimated time it will take for the company to make a settlement offer to your creditors.
- The amount of money, or percentage of each debt, that must be saved in an escrow account before a settlement offer can be made on your behalf.
- If the company advises you to stop paying creditors, they must inform you of the potential negative effects, such as damage to your credit, possible lawsuits, ongoing collection actions, and the continued accumulation of interest and fees.
Additional details the company must provide:
- The money in your escrow account is yours and you’re entitled to any interest earned.
- The account administrator is independent and does not receive referral fees from the debt relief provider.
- You can withdraw your money from the escrow account at any time without penalty.
DIY Debt Settlement: Handling Debt Negotiations on Your Own
If debt settlement still seems like the right choice for you, consider handling it on your own instead of going through a debt settlement company. You can negotiate directly with your creditors or hire a lawyer to represent you.
If negotiating by phone doesn’t appeal to you, you can send a letter to creditors explaining your situation and offering partial payment. Be sure to request that they remove any delinquent payments from your credit report.
Handling it yourself can save you a significant amount of money, though keep in mind that there are no guarantees. Creditors aren’t required to accept a settlement offer, as they are entitled to the full amount owed.
DIY debt settlement may also be an option if you’re facing a lawsuit over credit card debt. In this case, there may not be time to work with a debt settlement company. Creditors might prefer to settle with you rather than incur the costs of going to court, but be prepared to pay a large lump sum for the settlement.
Debt Settlement vs. Other Debt Relief Options
Debt settlement can take several years to complete, assuming your creditors agree to settle. You’ll likely make payments to the debt settlement company, similar to a debt consolidation loan or debt management program. However, unlike debt settlement, both debt consolidation and debt management typically won’t damage your credit if you make on-time payments. Additionally, debt settlement may not save you more than these other options once you factor in fees and tax implications.
For a comparison of debt settlement and debt management, click here.
When comparing debt settlement to bankruptcy, Chapter 7 bankruptcy can eliminate all of your debt, while debt settlement only addresses a portion of it.
How Does Debt Consolidation Differ from Debt Settlement?
Debt consolidation combines multiple debts into one, with a single interest rate and monthly payment. Instead of paying each bill separately, you make one payment to a financial institution or debt management company. This payment typically has a lower interest rate and is less than the total of your previous payments.
In contrast, debt settlement involves negotiating with creditors to accept a reduced payment, but you may need to deposit money into an escrow account until enough is saved to settle the debt.
While debt settlement may lower your overall balance, debt consolidation won’t harm your credit score in the same way that debt settlement can.
Credit Counseling: An Alternative to Debt Settlement
A reputable credit counseling provider can help you find a debt solution tailored to your financial situation. These nonprofit consumer agencies offer free counseling, including a budget evaluation, to assess your overall finances and provide recommendations for a customized solution. Based on your circumstances, the counselor may suggest a debt management program, which can reduce interest rates and fees on your accounts.
A debt management program is a solid alternative to debt settlement. Through this program, the credit counseling agency consolidates your payments into one monthly payment, without the need to borrow more money. You may also qualify for waived fees and lower interest rates. While you’ll still need to pay off your debt in full, the monthly fee for the nonprofit debt management program typically ranges from $30 to $50. Your accounts are paid on time each month, helping protect your credit score. These programs generally take 3-5 years to complete.
Credit Card Debt Forgiveness Program
Nonprofit agencies are generally a better option for debt settlement than for-profit companies. These agencies are supported by the National Foundation for Credit Counseling and follow federal regulations designed to ensure they act in the best interests of their clients.
While traditional nonprofit debt management programs don’t reduce balances, the new Credit Card Debt Forgiveness program allows qualifying consumers to pay only 50-60% of their debt balances. This program offers fixed payments, with the balance required to be paid off within 36 months, and no interest charged on the payments. It combines some of the best aspects of nonprofit debt management and debt settlement, while avoiding some of the risks associated with traditional debt settlement, including:
- The agreement with creditors to waive 40-50% of the debt is established upfront, so the borrower knows exactly what they will pay.
- Debt is paid off through fixed monthly payments over 36 months, rather than a lump sum payment typical of for-profit debt settlement programs.
- No interest is charged on the remaining balance, unlike for-profit programs where interest and late payment penalties accumulate until an agreement is made.
- Debt collectors are prohibited from contacting participants in nonprofit debt settlement programs.
A reputable nonprofit agency can help you determine if the Credit Card Debt Forgiveness program is the right fit for you. If not, they can guide you through other available debt relief options.