Debt Settlement
What is debt settlement and what are the risks?
Debt settlement is the process of negotiating with your creditors. You can do it yourself — or pay a third-party company to do it for you. It can be worthwhile for some, but debt settlement has its share of risks. Your credit score will almost certainly take a hit. Most importantly, your creditors may not agree to settle, leaving you with the same amount of debt as when you started.
What is debt settlement?
Debt settlement is when your debt is settled for less than what you currently owe, with the promise that you’ll pay the amount settled for in full.
Sometimes known as debt relief or debt adjustment, debt settlement is usually handled by a third-party company, although you could do it by yourself. Not all lenders accept debt settlements, and there are some instances where it could cause more financial harm than good.
What is a debt settlement company?
A debt settlement company acts as a middleman between you and your lenders and creditors to reduce or eliminate your debt. Sometimes it can be helpful to have an experienced guide to help you through an unfamiliar process.
But before working with a debt settlement company, understand its process and read reviews about the company. Different debt settlement companies offer different terms, so be sure to do your research.
How does debt settlement work?
You can settle your debt by yourself. Reach out to your creditors and explain your financial situation. It will take time and persistence, but you may be able to lower the amount you owe, change your interest rate or come to another form of agreement. While you and your creditors find a solution, you will continue to make the payments you owe.
If you opt for a third-party company or a lawyer, you will need to pay for their services as a flat fee or a percentage of your savings. This means that even if your debt is settled for less than what you owe, you still have additional costs outside your outstanding debt.
The debt settlement company will require you to stop paying your creditors and make payments into a savings account. That means depositing regular amounts into an account the company can use to pay your debt or collect the fees you owe. You may fall further behind on payments, and your credit score could plummet.
You will need to agree to the new terms if a settlement is reached — a lump-sum reduced amount, a lower monthly payment or a debt discharge. This needs to happen for settlement to move forward, but you’re not obligated to agree to any terms if you don’t want to. Depending on how the debt was settled, you may need to make payments to the company handling your debt until your outstanding debt is paid in full.
Risks of debt settlement
Debt settlement may seem like a convenient option, but the process has quite a few risks. In addition to finding a legitimate debt settlement company, you may need to wait years for your debts to be negotiated. Even if you do it yourself, you may not be able to avoid fees or a hit to your credit score.
You could face hefty fees
The fees associated with debt settlement services vary depending on local and state laws. It is not unusual for a third-party debt settlement professional to charge between 15 percent to 25 percent of the debt that gets resolved. That means if you’re seeking to settle a debt of $50,000, you’ll pay a fee based on that amount, not on the final negotiated repayment amount.
However, according to rules enacted by the Federal Trade Commission (FTC) in 2010, debt negotiation companies may charge fees only after they have resolved the debt for the client. Any debt settlement company or attorney that tries to charge you before the debt is settled is not legitimate. Avoid working with them; instead, find a reputable debt settlement professional who follows regulations.
Your credit score may be damaged
Going through the settlement process and resolving debt using this approach will likely negatively impact your credit score.
For instance, many debt settlement companies ask that you stop making payments on your credit card during negotiations. Lenders and creditors are not as likely to negotiate with consumers who can still make monthly payments on their bills. Not paying bills, of course, damages your credit.
“To settle, most creditors require that an account is in a delinquent status,” says debt attorney Leslie Tayne, founder of Tayne Law Group. “During the settlement process, an individual’s credit score will often take a hit while the accounts are in negotiation. This means you may also be sued.”
In addition, when accounts are marked as “settled” on credit reports, it can hurt your credit score.
Debt settlement is not as quick as you think
It is not unusual for the entire debt settlement process to take three to four years. Your attorney or debt settlement company will need time to negotiate with your creditors. The more creditors you have, the more time it will take. In addition, you will need time to build up the money in a savings account to pay off your debts in a lump sum.
Debt settlement is a long process. Expect for it to last years whether you work by yourself or with a third party. Patience is key, but it may make sense to consider some alternatives to debt settlement if you need relief from your debt sooner.
The forgiven debt is taxable
While it may be a relief to settle your debt, and possibly for less than you originally owed, you may now be on the hook with the IRS. Any forgiven debt over $600 is taxable. So, if a debt settlement company can negotiate $10,000 worth of debt down to $7,000, you will owe taxes on the $3,000 forgiven by your creditor.
Ideally, the money you pay your debt settlement company should also be enough to cover applicable taxes. However, you will need to check the fine print of any agreement you sign. If taxes are not included, you will be responsible for paying the remaining debt, the debt settlement company’s fee and the taxes.
You may owe more than when you started
When you begin the debt settlement process, the debt attorney or third-party company will often advise you to stop making payments on your debt. Interest will still accrue on that debt.
You may also begin racking up late fees and other charges. Ultimately, these charges may increase your debt to more than was originally owed. This could add complexity to your settlement and result in you not getting the relief from debt you expected.
You may not be able to settle
Not all companies will settle your outstanding debt. And even if they do agree to settle, some refuse to work with debt settlement companies. If you’ve agreed to follow the debt settlement company’s terms and haven’t been keeping up with your payments, this could make it more difficult to come to an arrangement with your creditor. Worse, your creditor may pursue legal action against you, incurring more costs and further harming your credit.
Alternatives to debt settlement
If debt settlement doesn’t work for your scenario, you have other options.
Bankruptcy
Bankruptcy is usually considered a last resort, but depending on your circumstances, it may be a more attractive option.
Filing for Chapter 7 bankruptcy will remove most outstanding debt, like credit cards, medical debt or other types of loans, but won’t remove back taxes, student loan debt or child support. This type of bankruptcy can take a few months to complete, compared to a few years with debt settlement. Neither option looks great on your credit report, but the sooner you remove or settle your debt, the sooner you can move on. If you want something faster, bankruptcy might be better than debt settlement.
Debt consolidation
Debt consolidation is when you combine all your debt into one new loan to pay off. It can reduce the amount of outstanding interest you owe and lets you make one manageable payment per month rather than many.
You can use a nonprofit credit counseling agency to help you through debt consolidation or go through it on your own using a debt consolidation loan.
Credit counseling
A nonprofit credit counseling agency can help you come up with a debt management plan that allows you to pay off your debt in circumstances that work best for your finances. Sometimes, credit counseling agencies will work similarly to debt settlement companies. Some companies have little to no cost for you, but you’ll make payments to them rather than to your creditors. You’ll usually close all outstanding accounts — like credit cards — until your debt is paid off.
Before starting, ensure that you’re working with an accredited agency, like American Consumer Credit Counseling, the National Foundation for Credit Counseling or Financial Counseling Association of America.
Balance transfers
A balance transfer is when you move your outstanding credit card debt to a new credit card that offers 0 percent APR for a set amount of time, usually between 12 and 24 months. This means you’ll be able to make low monthly payments without the extra cost of interest added to your outstanding balance every month. But once the 0 percent interest term ends, you’ll get charged interest on anything that isn’t paid in full every month.
The best balance transfer credit cards won’t charge a fee to transfer your outstanding balance. But keep in mind that not all balance transfer credit cards will transfer your full outstanding balance. This could mean that you’re on the hook for paying off your new balance and whatever didn’t transfer over.
Beware of debt settlement scams
While many companies look out for your best interest, some debt settlement companies are scams. You can avoid fraudsters by:
- Avoiding businesses that make false promises: If a company says that it can make your debt go away and stop debt lawsuits and collections, beware. Remember, your creditor isn’t obligated to accept a settlement, and some won’t work with debt settlement companies. Getting your debt and related problems to disappear is not a guarantee.
- Not paying fees before debt settlement: If your debt settlement company requires money before it’s done any work, that’s a red flag. Read the fine print when it asks for payment, and make sure that you know what it’s going toward.
- Keeping up with communications: If your debt settlement company doesn’t tell you about the risks involved in debt settlement or the consequences of not making payments to your debt collectors, that’s a problem. You should know every risk before handing over your money (or pausing payments), and it’s your debt settlement company’s job to make sure that you’re aware of what’s at stake.
Debt Negotiation Tips
Whether you use a professional or not, you'll want to explain your financial situation to your lender. If your lender understands that you cannot pay your bills, they will be more likely to work with you on a solution to avoid you failing to pay make it less likely that they reject your offer.
You should also avoid spending with a credit card that has a balance you want to settle. Lenders are less likely to settle if your credit card statement includes, for example, several charges for luxury goods. To improve your chance of success negotiating with a credit card company, try to avoid using it for three- to six-months before you request a settlement.
What Percentage Should I Offer to Settle Debt?
Consider starting debt settlement negotiations by offering to pay a lump sum of 25% of your outstanding balance in exchange for debt forgiveness. However, expect the credit card company to counter with a request for a greater amount.
Do Settlements Hurt Your Credit?
Debt settlement can help you financial situation, but it can hurt your credit score and make it more difficult for you to get financing in the future. With a lower credit score, you may find that you only qualify for loans with higher interest rates, which will add to your total borrowing costs.
How Do You Remove Debt Settlement From Your Credit Report?
When you settle an account with a lender, it will remain on your credit report for about seven years and will negatively affect your credit score. You cannot remove debt settlement from your credit report before then.
Debt Settlement vs. Minimum Monthly Payments
Making minimum monthly payments on high-interest debt is not a good option for consumers who want to save money. It can take years—decades, even—depending on how much debt you have and what the interest rate is. Interest compounds every day on your entire balance, and with minimum payments, you make little progress paying your balance down each month.
Consistently making minimum monthly payments and forking over tons of interest might make you highly profitable to your creditors, and, yes, solid payment history is good for your credit score. However, we don’t recommend spending more than you have to on interest to boost your credit score. A good credit score won’t pay for your retirement; money in the bank will.
Further, if the amount of available credit you’ve used is high relative to your credit line, that will hurt your credit score and potentially negate the effect of your consistent, timely payments. The AFCC report cites that "the average client reduced their total debt at the time of settlement of approximately $30,000 to $35,000 by roughly $9,500 after deducting fees.
Consumer who consistently make just the minimum monthly payment on high interest credit card debt can end in paying more in interest than the principal.
Debt Settlement vs. Credit Counseling
Credit counseling is a free or inexpensive service provided by nonprofits and government agencies. Interestingly, these services are often partly funded by credit card companies. By enrolling in a debt management plan with a credit counseling agency, you may receive an interest rate reduction on your balances and a waiver of penalty fees.
Those concessions may or may not be sufficient to help you pay down your debt considerably faster, and you may or may not be able to afford the new required monthly payments. In addition, you may not qualify for an interest rate reduction, even if you have a significant financial hardship.
However, because you won’t have to default on your debt, your credit score may suffer less. Also, credit counseling may offer additional financial assistance that can help you avoid similar problems in the future, such as budget development and financial counseling, and referrals to low-cost services and assistance programs to help you reduce your expenses.
So how do you know which to choose if you don’t want to pursue bankruptcy? Credit counseling is usually better to pursue before considering contracting a debt settlement company. Credit counselors can help you determine the best course of action which may include debt settlement, but in a way that benefits you and not necessarily a debt settlement company that is interested more in you as a client than your credit health.
Credit counseling and consolidation loans are appropriate for consumers with more modest financial stress on the spectrum of financial hardship. At the same time, debt settlement and bankruptcy can help those who have more significant financial stress, but it is very dependent on the individual situation.
The Federal Trade Commission website has helpful information about how to choose a credit counselor.
The National Foundation for Credit Counseling is another good resource.
The Bottom Line
You can potentially lower your credit card debt by negotiating with a lender either on your own or with a debt settlement company, but keep in mind that a creditor is not legally obligated to settle on a different payment amount other than what you owe.
If you cannot lower your total debt obligations, you can turn to other strategies that can help you stay in good financial health. For example, you may want to ask your credit card company if it can lower your card’s annual percentage rate (APR), reduce your monthly payment amount, or provide an alternative payment plan. You can also consider debt consolidation through an additional loan that results in lower monthly payments.
For more guidance on the best options for your specific situation, consider consulting a professional financial advisor.
While debt settlement might sound like a great idea, it’s not always the best option for tackling your debt. Some creditors and debt collection agencies don’t work with debt settlement companies, and some don’t do settlements at all. And even if they do, it could take years before a settlement is reached. Imagine waiting to pay multiple types of debt and the damage it could do to your credit during that time.
You have other options, including debt consolidation, debt management plans, credit card balance transfers and even bankruptcy. Evaluate all your options before deciding, and don’t be afraid to change course if it’s not working out like you expected.