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How Does Debt Settlement Work?
By Quinlan Grim MONEY RESEARCH COLLECTIVE
Debt settlement is the process of negotiating with debt collectors to pay less than what you ultimately owe. It can help you get out of a tight spot when the bills are piling up, but it isn’t risk-free — this process will affect your credit and can come with steep fees.
Is debt settlement worth it? This guide will walk you through the debt settlement process, including pros, cons and tips on how to settle debt.
What is a debt settlement?
A debt settlement is an agreement between you and your creditors to absolve your unsecured debt by paying less than what you owe. You may have also heard it called “debt relief” or “debt adjustment.” Keep in mind that debt settlement is NOT:
- Debt forgiveness — A settlement is an agreement to pay less than the total amount you owe. This process won’t erase all your debt.
- Debt consolidation — Consolidation is the process of combining your debt from various creditors into one loan. This can help to reduce your outstanding interest and make monthly payments simpler.
- Bankruptcy — Settling debt is not the same as declaring bankruptcy. When it comes to deciding between bankruptcy vs. debt settlement, you should know that debt settlement will take much longer, but the damage to your credit may not be as bad.
Debt settlement isn’t an easy way out of your loans. It should be seen as a last resort to lower your financial burden and avoid bankruptcy. You may have to sacrifice your good credit score and pay significant fees to settle a debt through this process, so it isn’t a decision to make lightly.
How debt settlement works
You can negotiate a debt settlement on your own. But most people choose to work with a reputable third-party company. This process can be complicated and often takes multiple years, so having expert support is helpful.
To reach a debt settlement, you must prove that:
- You can’t reasonably pay the amount you owe.
- You can pay the new amount outlined in the settlement on time.
Creditors are not inclined to lower a borrower’s payments unless it’s worth their while. In other words, the process of negotiating a debt settlement means proving that the creditor will get more value by accepting what you can pay than by pursuing the full amount.
If you choose to work with a third-party debt settlement company, a lawyer or financial expert will advocate for the settlement on your behalf. They will most likely have you enter a debt settlement program while they negotiate your settlement.
Most debt settlement programs require you to stop paying creditors and make monthly payments to a savings account instead. That way, the company can take its fees out of the account and use the rest to pay off your debt once the settlement is reached. Missing payments to your creditor will affect your credit score and lead to penalties, but you will still save in the long run if your settlement is successful.
Understanding debt settlement laws
Debt settlement is a legal process. However, there are plenty of illegal scams out there. Be cautious of companies that offer “quick” or “instant” debt settlements. A few legitimate, high-quality debt settlement companies include:
- New Era Debt Relief
- National Debt Relief
- Freedom Debt Relief
- Accredited Debt Relief
Be sure to read a company’s online reviews and credentials before you agree to work with them. Debt settlement laws vary by state, so you might want to work with a local expert who knows your state’s policies.
Creditors are not legally obligated to agree to your debt settlement. On that note, debt settlement companies can’t guarantee that your debt will be settled. According to debt settlement law, these companies can’t charge an upfront fee for their services — instead, they charge a percentage of your enrolled debt. Any company that charges an upfront fee is an illegal service.
The advantages of settling a debt
Debt settlement can get you out of a tight spot when you really need it. The advantages of this process include reducing the total amount you owe, avoiding bankruptcy and ending those stressful collection calls.
Reduced amount of debt
The ultimate purpose of debt settlement is to reduce the total amount of debt you owe. If your settlement is successful, you’ll resolve your debt by paying less than you originally owed your creditors.
The exact amount you will save varies by each case. It can sometimes be as much as 50%, depending on the amount you owe and whether you work with a debt settlement company. Remember, this isn’t debt erasure — you will still have to pay your creditors. But with debt settlement, you can have your loans paid off faster and get back on track toward saving and improving your credit score.
An alternative to bankruptcy
Bankruptcy can be a last resort to get you out of debt. When you file for bankruptcy, the IRS absolves most of your outstanding debts, including child support or student loans. This process is generally faster than debt settlement. However, bankruptcy is always harmful to your credit score and will remain on your credit report for 10 years after you file.
Debt settlement also harms your credit but may not be as destructive as bankruptcy. A debt settlement stays on your credit report for seven years after the first missed payment — not seven years after the debt is paid.
Debt collection calls cease
As long as you avoid payments, debt collection agencies will keep calling. Debt settlement can put you on track to paying off your loans faster and ending the calls.
In addition, your debt settlement attorney can help advocate for you and stop the calls while you’re in the process of settling your debt. Once your creditor knows you’re working toward a debt settlement, they might slow or cease their communication with you and talk to your lawyer instead.
The risks of settling a debt
Debt settlement is not always the best path out of debt. This process is not guaranteed and might take up to four years. Also, it’s harmful to your credit score and could cost you more than you owed in the first place.
Harm to your credit score
Debt settlement will affect your credit score. It may not be as harmful as bankruptcy, but it’s definitely counterproductive if you’re trying to build good credit.
A debt settlement can hurt your credit score in two ways:
- Missed payments — As a part of your debt settlement program, you will most likely have to neglect payments to your creditor. This encourages the creditor to settle your debt, but in the meantime, those missed payments will affect your credit score and cause you to lose points.
- Accounts marked as “settled” — A settled debt stays on your credit report for seven years from the first delinquency. An account marked as “settled” can negatively impact your credit score, as it shows you couldn’t fully pay off a loan.
A bad credit score can be fixed. You can take measures to build back your credit after your debt settlement — over time, you might be able to remove charge-offs or remove collections from your credit report and see your score go up again.
Still, a big drop in your credit score can affect your financial future and make it more difficult to take out home loans, get a credit card or make a big purchase. You shouldn’t pursue a debt settlement unless you have no choice but to let your credit take a hit.
Your creditor might refuse
Your creditor is not legally obligated to accept your debt settlement. There’s no guarantee that your debt will be settled at the end of this process.
If your creditor refuses a settlement, the best thing you can do is set up a debt management plan and start making payments. The penalties incurred during the settlement attempt might eventually lead to bankruptcy if there’s no way you can pay them.
Fees could cause you to owe more than what you started with
Third-party debt settlement companies are not legally allowed to charge an upfront fee. You won’t have to pay if your debt settlement is flat-out refused.
However, some settlements can result in a partial payment reduction. Your creditor might agree to reduce a smaller amount than your attorney requests. In that case, you must still pay the debt settlement company. Those fees, plus the late fees and interest that collect while you’re pursuing the settlement, can add up to more than you originally owed.
Talk to your debt settlement attorney before you start the settlement process. A reliable attorney should be honest with you about your chances of reaching a full settlement — if there’s a chance your reduced debt will be less than the total fees, it isn’t worth it.
How to negotiate a debt settlement on your own
If you want to avoid the fees of a debt relief company, you can try to negotiate your loan or credit card debt settlement on your own. This is a time consuming and risky process. Working with a company is the safest way to pursue a debt settlement.
Negotiating a debt settlement on your own involves these basic steps:
- Research your creditors
- Start a settlement fund and halt payments
- Make an offer to the creditor
- Agree to a settled amount in writing
- Pay off the settled amount
Your creditor will likely ask you to pay the settled amount in a lump sum or a few monthly payments. Make sure you have enough money set aside in your settlement fund to pay the agreed-upon amount.
Debt settlement is a risky process no matter what, but even more so if you choose to negotiate on your own. Creditors can sue you for the amount you owe. The safest choice is to work with a professional.
What percentage should you offer to settle a debt?
Negotiating a debt settlement takes time. There will most likely be a lot of back-and-forth communication, especially if you choose to negotiate on your own.
Your opening offer can be as little as 25% of your remaining debt. The creditor may accept if you can pay that amount as a lump sum. Chances are, they will continue negotiating.
Every situation is different. Your final settlement will depend on the amount you owe, your taxable income, how far behind you are on your payments, the creditor you’re working with and several other factors. Again, working with a professional is the best way to improve your chances of getting the best settlement.
What is a debt settlement company?
A debt settlement company or debt relief company is a for-profit business that will negotiate a debt settlement on your behalf. They charge consumers a percentage of their enrolled debt to facilitate the settlement.
Be cautious of scams. You should only hire a debt settlement company that is transparent about its rate charges, has good reviews and offers a free initial consultation, so you know what to expect.
Bankruptcy vs. debt settlement vs. debt consolidation
As discussed above, a debt settlement is not the same thing as a bankruptcy or debt consolidation. These are alternative solutions to help you absolve your debt.
- Debt consolidation — This program combines all your debts into one loan. It can lower interest rates, but you will still pay the full amount you owe. This is the best solution to preserve your credit.
- Bankruptcy — Filing for bankruptcy will absolve your outstanding debts but can be devastating to your credit and stays on your credit score for 10 years after you file. This should only be used as a last resort to manage severe debt.
Is debt settlement worth it?
Considering the pros and cons of debt settlement, is it worth it? That depends on your situation.
Debt settlement can be used to manage your debt if your only other option is bankruptcy. If there is any way you can manage your payments without a settlement, it’s always better to pay off your debts in full. A debt settlement might take years and can severely affect your credit score.
If you decide to pursue a debt settlement, make sure you work with a reputable third-party company. Afterward, take steps to rebuild your savings and recover your credit. You can get your credit back on track in time if you carefully manage your spending and dispute credit report errors.