What is Debt Settlement? How Does It Work?
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When you're saddled with lots of debt, chances are you're feeling stressed out by the constant calls from collection agencies and worried you'll never be able to pay off all your debts in full. With multiple obligations to deal with every month, plus the anxiety of debt collectors, you have to decide between making the minimum payment on your credit card debt and student loan payments while covering your living expenses and keeping a roof over your head. While taking on a second or third job may help, you can't sustain that for long. Living on a tight budget is difficult enough when you're not facing mountains of debt.
But this is when debt settlement may be of use to you.
In this article
What is debt settlement?
Debt settlement is a process by which parties who owe money to one another negotiate an agreement to pay back the debt in full, with interest and/or a discount. It is an alternative to bankruptcy and debt consolidation, which involves paying back debt with funds from a loan or by spreading payments out over a longer period of time. If the other party does not agree to the debt settlement offer, then the debtor must file for bankruptcy or apply for a debt consolidation loan.
Although debt settlement can be an effective way to get out of debt, it is a risky option. In many cases, people who participate in debt settlement wind up worse off than if they had just filed for Chapter 7 bankruptcy or consolidated their debt. Before you consider debt settlement, make sure you've explored all of your other options first. You should also be aware that not all debt settlement companies operate ethically.
How does debt settlement work?
A debt settlement company will typically work with you to reduce the amount of debt that you owe to your creditors by negotiating a settlement agreement with your creditors on your behalf. Once the debt settlement process begins, you're advised to stop making payments on the debt, which may incur late fees and hurt your score. For the record, if you have high credit card balances, you don't need the services of a company and can negotiate directly with credit card companies.
Typically, the company providing settlement services will contact all of your creditors and let them know that you are making efforts to settle your debts but that you cannot make the monthly payments required under the terms of your original agreement. For example, they may be able to negotiate a reduction in the amount you have to repay each month to make your payments more affordable. The debt negotiation may also include a lower interest rate so that more of your payment is applied toward the principal balance and less goes toward interest charges. In some cases, you may eliminate some of your other debts, such as late payment fees and collection fees, which can help reduce your overall debt.
important: Forgiven debt of more than $600 is taxed by the IRS because the agency considers it to be taxable income.
Your creditors may then be willing to work with you to reduce your monthly payments or even eliminate some of the fees you must pay in exchange for cooperation. In many cases, this will allow them to collect more from you than they would if you continued to make regular payments under the original terms of your agreement. Once a settlement has been reached, the debt settlement company will send you the funds necessary to pay off your debt and will provide you with a detailed accounting of how much money was spent on these services so you can make the appropriate payments as needed. Generally, these companies charge you a certain percentage of the settled debt.
This type of arrangement is best used for people who have fallen behind on their bills and are struggling to come up with money to make their monthly payments. However, it is not a good solution for people who are only delinquent on one or two of their bills and are trying to improve their credit to qualify for new loans in the future. In many cases, the creditors are only willing to work with debtors in serious financial distress and cannot come up with the money to make their monthly payments.
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Alternatives to debt settlement
Depending on your situation, there are a few alternatives to debt settlement that you may wish to consider before pursuing this option:
Debt consolidation
A debt consolidation loan allows you to combine all your high-interest rate debts into a single monthly payment with a lower interest rate. This gives you more financial freedom and lower monthly payments which can help you manage your debt more effectively. However, it's important to remember that a debt consolidation loan will not make you debt-free. Your total debt burden remains unchanged after you get the loan. If your new loan has a lower interest rate than your current loans, you can reduce your total interest expense by making smaller monthly payments. But there's no guarantee that you'll be able to pay off your loan earlier than expected or pay off various types of debt completely within a specific period of time.
This option will pay off your outstanding debts with a bank or other financial institution consolidation loan. This could take the form of a lump-sum payment, or you could make one monthly payment to the loan company instead of paying multiple creditors each month. As a result, you'll have fewer bills to pay. Some lenders will offer unsecured debt loans with no collateral, like personal loans, while others will require you to provide your home or car as collateral for the loan. If you choose this option, shopping around to find a low-interest debt consolidation loan that best fits your needs is important.
While it is not the best solution for everyone, debt consolidation can often be a viable option for those with less-than-perfect credit trying to control their financial situation. It is also an option for those who are experiencing significant financial difficulty and can no longer afford to pay their debts on time.
Related: Debt Consolidation for Bad Credit
Debt relief programs
These programs may also offer credit counseling services to help the consumer improve their personal finance skills and manage their money more effectively in the future. Debt relief programs may be offered through the courts, government agencies, nonprofit organizations, or private companies. They are generally designed to help those struggling financially and have no other resources available to help them get out of debt. However, a debt relief company's services will not eliminate all of your debts - it will only reduce the amount of your monthly repayment.
A credit counseling agency can help you formulate a debt management plan, and a credit counselor may suggest a lump-sum payment if that's something you can afford. These companies can help people understand their debt and learn how to reduce their liabilities through better money management habits. They can also help you negotiate lower interest rates with your creditors so that more of your monthly payment goes to the principal amount owed and less to the interest charged. Many of these programs are free, but some may charge a small fee.
Legit companies providing debt relief services include American Debt Relief, Accredited Debt Relief, National Debt Relief, and Freedom Debt Relief.
Bankruptcy
This option is for those with a good credit score and many assets to protect. Filing for a Chapter 7 bankruptcy will stop all collection activity on the debts you owe and allow you to make a fresh start. Your assets will be protected in most cases, and you will still be legally required to pay back your debts after closing the case. However, you should remember that bankruptcies remain on your credit report for up to 10 years and will negatively impact your credit score.
But filing for bankruptcy gives your credit score a much-needed boost because it erases your outstanding debts and restores your financial credibility in the eyes of your creditors. It also gives you a fresh start, allowing you to take control of your finances and rebuild your credit from scratch.
Advantages of debt settlement
First and foremost, settling your debts can result in significant savings in interest charges and fees. By settling debts for less money, the debtor can avoid costly penalties and save significantly.
In addition, a debt settlement plan through a reputable agency can help to improve your credit rating and increase the likelihood that you will be able to obtain loans or apply for credit cards or other services in the future. It can also be easier to get approved for mortgages and other types of financing in some cases as well. Finally, you may be able to settle some of your debts for less than what you currently owe. This can be particularly beneficial if you have expensive debts such as medical bills or student loans that can be difficult to pay off.
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Disadvantages of debt settlement
While debt settlement can be an effective way to save time and money, it also has several disadvantages you should keep in mind before making a final decision. For one thing, you will be unable to avoid paying back all the money you borrow through this process. As a result, you will still be required to make payments to your creditors until they are paid in full. This can lead to problems if you cannot keep up with payments or if your creditors refuse to give you additional time to pay them.
In addition, many debt settlement companies charge high fees for their services. This means they could end up charging you hundreds of dollars or more simply to settle your debts. In some cases, these companies may also require you to pay additional fees to have your accounts removed from your credit report once they have been settled. This can significantly increase your total cost of using their services and put you in a difficult financial situation if you don't have the means to cover these expenses.
Some debt settlement scams, veiled as legitimate companies, provide their clients with deceptive or misleading information to help them to qualify for these programs. This can lead to financial difficulties for borrowers in the long run and may even cause them to spend more money than they originally expected to. The Consumer Financial Protection Bureau advises that customers do their due diligence before engaging a debt settlement company. You can also look up the service provider on Better Business Bureau's website.
The bottom line
Debt settlement is a process through which individuals can negotiate with their creditors to lower their debt. Generally, creditors will offer a lower amount of debt than what is owed to make the debtor more likely to settle rather than continue to pursue payments. Before agreeing to a settlement, it is important to weigh the pros and cons of the process to ensure that it is the best option for your situation.
By paying off your outstanding balances and making regular payments, you will be able to demonstrate to potential lenders that you can make timely payments and can be trusted to pay them back if they extend you new credit. On the other hand, if you decide to file for bankruptcy, your credit score will be negatively impacted for as much as 10 years.
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Writer
Jasir Jawaid is Joy Wallet's Assistant Editor. He has more than 13 years of experience as a journalist covering Wall Street, equities, financial policy and regulation, and cryptocurrency and blockchain.
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