Do you owe more than you can possibly pay? Debt settlement might be the answer you’re looking for. There are serious risks and it’s not a solution to take lightly, but it may allow you to permanently retire your debts while paying much less than you actually owe.
In this post:
Debt Settlement in a Nutshell
Debt settlement is an agreement between borrower and lender that allows the borrower to pay off (settle) their debts for less than their current balances. It can prevent an account from going into collections or resolve an account that’s already in collections.
Debt settlement can completely eliminate debt. Once a settlement is concluded and you pay the agreed amount, the debt is gone. No more collection calls, no more payments. You don’t owe the money any more. The downsides? Not all settlement efforts succeed. Negotiating on your own behalf can be difficult, and hiring a company to do it for you can expose you to a whole range of shady practices. If you do succeed in settling debts, your creditors will forget the debt but the credit reporting companies won’t. Your credit will probably take a significant hit.
The potential downsides are significant, but if you are desperate and other relief options have failed, debt settlement can be a viable alternative to bankruptcy. Here’s what you need to know.
How Does Debt Settlement Work?
Debt settlement is an option to consider after you’ve exhausted all other debt repayment options. That means you can’t make your monthly payments even after using other forms of debt relief to make them more affordable.
Your creditor will not make a debt settlement offer: you will have to initiate the process. You will inform the creditor that you cannot pay the debt in full and offer to pay what you can in exchange for closing the debt. You can do this yourself or have a debt settlement company do it for you.
Your creditors will only consider settlement offers if they believe that they will not be able to collect the full amount you owe. Don’t bother faking greater financial distress than you’re experiencing. Lenders have access to your credit reports. That gives them enough insight into your financial situation to recognize a bluff. A settlement isn’t desirable unless you have no other options anyway.
What Debts Can You Settle?
Debt settlement will usually only work with unsecured debts. If you have secured debts like mortgages or auto loans, lenders can repossess the collateral to get their money back. They’ll foreclose on your house or seize your car, then sell it.
Unsecured debts (like credit card debt) are different. A creditor that cannot collect from you has few options beyond selling your debt to a collection agency. If they do this, they will get an average of 4 cents for every dollar you owe. If your settlement offer will make them more than that, they may consider it.
If you owe money to a collection agency, they probably paid that same 4 cents on the dollar for your debt. Because it represents a minimal investment, they may be willing to listen to a settlement offer that allows them to make a profit.
If a creditor or collection agency believes you’re considering bankruptcy, they may be more inclined to accept a settlement offer. Unsecured debts are often discharged in bankruptcy. If that happens, the creditor ends up with nothing.
If your creditor accepts a settlement offer, your account will be closed once you pay the agreed amount. They will no longer attempt to collect.
Debt Settlement vs. Other Forms of Debt Relief
Debt consolidation and refinancing can adjust the terms of your debts. They can lower your interest rate or monthly payment, but you’ll still have to pay off your entire principal balance. Credit counseling can help you strategize more effectively, but it won’t change the terms of your debts at all.
That makes debt settlement unique. Short of bankruptcy, it’s the only debt relief option that will let you out of your obligations without having to pay the full balance.
📘 Learn about other forms of debt relief: Debt Relief Options
Debt settlement is considered partial debt forgiveness. The Internal Revenue Service (IRS) considers any forgiven debts to be taxable income. The foregone portion of your debt must be added to your taxable income. Consider that potential liability before making a debt settlement offer.
Who Provides Debt Settlement Services?
If you’re seriously in debt, you may have considered retaining a debt settlement company. You have very likely heard from several of them. These companies advertise heavily, and they target people with high levels of debt.
Debt settlement companies specialize in negotiating with creditors. You’ll have to pay for their services. The fees are usually a percentage of your original debt balance or a percentage of the amount they cut from your debt. They can’t legally charge you until they settle your debt. If a company tries to bill you before then, don’t work with them. Be wary of any company that boasts a promised percentage reduction. The Consumer Financial Protection Bureau lists that as one common sign of a scam.
Debt settlement companies will encourage (or require) you to stop making payments toward the debts you want to settle. Their reasoning is simple: if you’re still making payments toward a debt, the creditor has no reason to negotiate. Instead, they’ll have you make your payments to a savings account that you can use to pay any creditor that accepts their offer.
Negotiations take time, and you may have to pay into the savings account for years. That can be challenging to sustain when you can’t make your debt payments in the first place. While you’re not making payments toward your debts, penalties and interest will continue to accrue. If you fail to complete the program or the negotiations fall through, you’ll be in an even worse situation than before. Your debts will be larger and your credit will probably be worse.
Finding a Debt Settlement Company: Buyer Beware
Finding a legitimate company can be difficult. It requires careful research since you’ll need to screen for one that’s trustworthy, competent, and affordable.
Debt settlement companies are not allowed to charge you until they settle an account, but their fees are significant once they do. They often bill as much as 25% of the original debt balance. There may also be fees for managing the savings account you contribute to.
The combination of fees, penalties, and interest combined with tax liability for the foregone amount might eliminate any benefit you receive from the settlement.
Watch Out For Scams
If you’re going to engage a debt settlement company, be wary of anyone offering something that sounds too good to be true. That includes anyone who guarantees they’ll be successful or promises that they can magically repair your credit. Read our article on how to spot debt relief and credit repair scams to learn what to watch out for.
When in doubt, err on the side of caution. Do your research and educate yourself thoroughly on all the other options before you consider a debt settlement plan. The Federal Trade Commission offers these recommendations on looking for a debt settlement company, and they are worth considering.
It’s also a good idea to consult with an affordable financial professional before you give any money or personal information to a settlement company. A non-profit credit counselor will be able to point you in the right direction, and many credit counselors offer initial sessions free of charge.
Can You Settle Debts On Your Own?
It might be helpful to engage a reputable debt settlement company, but it’s not a requirement. You can negotiate on your own and avoid the hassle of finding, vetting, and working with a third party. Debt settlement companies are a dime a dozen, and it’s not easy to separate the good ones from the bad.
Doing it yourself can also save you the money you’d otherwise spend on fees. It can also eliminate one of the worst possible scenarios: paying a company with no results but more debts and ruined credit.
There are also drawbacks to DIY debt settlement. Most consumers aren’t finance experts. There’s a learning curve to financial negotiations, and an experienced professional may be more likely to succeed than a first-timer.
Debt settlement negotiations take time. You might not be able to keep up with the demands of ongoing negotiations on top of your other responsibilities.
If you do decide to attempt debt settlement on your own, you’ll be drafting letters to your creditors stating that you are unable to pay your full debt and offering to settle the debt for less. Do some research on debt settlement letters and be sure that you are able to pay what you offer!
Don’t expect an immediate favorable response. Your creditors want to be paid in full, and they will not give in just because you write a letter. Be prepared for a negotiation process.
How Does Debt Settlement Affect Your Credit Score?
Debt settlement will have a significant negative impact on your credit score. It might not be quite as bad as a bankruptcy, but it may be more difficult to obtain new credit for a while.
Debt settlements can hurt your credit score in three ways:
- You may have to stop making payments during the negotiation process, which will further tarnish your payment history.
- Your creditor could choose to sell your account to a collection agency while you pursue negotiations. Collection accounts are not good for your credit.
- If you successfully negotiate a deal, your lender will report the settlement to the credit reporting companies. Settled accounts stay on your credit report for seven years.
Debt settlement doesn’t permanently sentence you to a life without credit. The impact of settled debts will diminish over time and after 7 years the debts will drop off your credit report. With patience and discipline, you can rebuild your credit score over time.
Should You Settle Your Debts?
Debt settlement can seem appealing. If you’re deep in debt and collectors are chasing you on a daily basis, the thought of seeing those debts permanently retired can be very appealing.
That doesn’t mean debt settlement is a great option. It can be hard to do and it exposes you to significant risks. If there’s any realistic possibility of paying your debts in full, it’s usually a better option to bite the bullet and do it. If there is no possibility of paying your debts in full, debt settlement becomes a viable option that can be less expensive and less intrusive than bankruptcy. As a general rule, consider debt settlement only when the alternative is bankruptcy. It won’t be an ideal solution, but it can be better than the alternative.
📘 Recovering from debt settlement is similar to recovering from bankruptcy. Learn how to rebuild your credit afterward: Life After Bankruptcy: How to Rebuild Your Credit and Your Finances.
Do you have any questions about debt settlement? Let us know in the comments section below!