What is Debt Settlement?
Debt settlement is a legitimate method of debt repayment that can be quite beneficial for consumers in certain circumstances. It’s also an industry that’s been plagued in the past by companies and individuals willing to take advantage of consumers in need.
Much of what made debt settlement feel like a dangerous option in the past has changed. Creditor attitudes and credit scoring models have both become more accommodating to settlement. However, it’s still incredibly important that consumers understand what it means to settle their debt and ensure they’re working with a trustworthy settlement agency before signing an agreement.
What is debt settlement, anyway?
Debt settlement is the process of paying off debt to a creditor after mutually agreeing to a sum less than what is owed. Usually only unsecured debt, such as credit cards and medical bills, is eligible for settlement. This can be done with the assistance of a debt settlement company or, in some cases, an individual may choose to do this on her/his own.
The Debt Settlement Process
Debt settlement programs usually involve the consumer discontinuing their payments to their creditor or creditors, and instead making payments to the debt settlement company, with funds going into an account earmarked specifically for the client’s personal settlement. These payments are generally much lower than the consumers’ regular minimum payments, which is what makes debt settlement an attractive option for consumers with more debt than they can reasonably afford.
Since the creditors are no longer receiving payments, the accounts become increasingly delinquent, eventually reaching the point where the creditor may choose to write off the debt as a loss. Around this stage, the settlement company begins negotiations with the creditors. Once the consumer accepts the creditors’ settlement offer the settlement company will use the accumulated funds to make a lump payoff or to start making payments towards the agreed upon settlement (for significantly less than the debt’s full value).
Most settlement companies negotiate with creditors to create a structured repayment plan. These plans are usually completed within 24 to 36 months, with client payments going out to creditors regularly.
Once all the agreed upon payments have been made, the debt is considered settled by the creditor and no additional payments should be needed. For the creditor, the settlement amount is usually greater than the amount they may have received selling the delinquent debt to a collection agency, which makes settlement appealing in the event the consumer is struggling to make their regular payments.
Debt Settlement Pitfalls
While debt settlement can be good option for distressed consumers with too much debt and not enough income, there are some very important things you need to know about settlement before taking the plunge.
There are no guarantees that you’ll be able to settle all of your debt. Although debt settlement is a large industry and has negotiated many settlements with many creditors, there is no guarantee they will be able to settle all of your debt.
Debt settlement won’t prevent debt collection activities. As you become delinquent with your creditors, they may continue to attempt to collect their debt, including the possibility of them suing you for the unpaid debts.
You have to follow through on your agreement. If something happens and you are forced to miss payments you could lose the offered settlement amount and be responsible for the remainder of the entire balance.
You could face tax implications on the forgiven debt. You could get a 1099 from the creditors in the amount of the debt that they have forgiven. You may have to pay taxes on that forgiven debt. Seek the advice of a tax advisor to understand if you would be impacted.
Finally, there are also fees associated with debt settlement and it can have a significant impact on your credit score. Read on to learn more about those aspects of debt settlement.
Debt Settlement Fees
In 2010, the Federal Trade Commission (FTC) issued a number of new rules designed to prevent potentially harmful debt settlement practices. One critical new rule was that debt settlement companies could no longer charge all their client fees in advance, before they had negotiated a settlement for the consumer.
Today, it’s common for debt settlement companies to collect their fees after a settlement is agreed upon by the consumer. They may take their entire fee after the consumer has accepted the creditors’ settlement offer (assuming there are enough of the consumers’ funds accumulated), or they may take their fee over a series of payments. The amount you’re charged for a debt settlement plan will vary depending on the agency and the size of your debts. At present, there are two popular fee structures for debt settlement:
- Pay a percentage of your total debt (usually between 20-30 percent)
Example: you owe $30,000 and the settlement company charges 25 percent. You would pay them $7,500.
- Pay a percentage of the amount that you save (highly variable)
Example: you settle a $50,000 debt at 50 percent ($25,000) and then owe the debt settlement company $5,000 (in this case, 20 percent of the $25,000 you saved).
On top of this, companies may charge an additional monthly fee to be in their program.
How does debt settlement affect your credit score?
Another big concern with debt settlement is the effect it can have on your credit score. Compared to other debt relief options, debt settlement typically has a much more negative impact. In fact, the NFCC warns that your credit score may drop between 65 to 125 points as a result of this type of program.
This is primarily because your accounts will go delinquent prior to the completion of your settlement program. A single missed payment can have a significant impact on your score, and settlements typically involve months of missed payments across multiple accounts.
That damage will stick with you for a while. Even after you’ve successfully completed your repayment program, those negative marks will usually remain until they naturally fall off your credit report over time. The good news, however, is that – at least in the FICO scoring model – once an account is successfully settled, it’s no longer considered as part of your score. (To be clear, all those missed payments will still stick around – it’s the fact that your account was charged off and eventually settled that no longer factors into your score.) This is good overall; however, keep in mind that most settlement programs take 24 to 36 months to complete. Until the debts are fully settled, those accounts will be listed as being in collections, which is very likely to hurt your credit (even more).
Of course, if you’re considering debt settlement, there’s a good chance your credit may already be suffering due to missed payments, so the damage caused by settlement may be pretty minor in the grand scheme.
Alternatives to debt settlement
There are several alternatives to debt settlement. The first is the DIY method. You could use either the debt ladder or the debt snowball to pay off your accounts all by yourself. If you have a hard time with this, you could always reach out to the creditor, explain your situation, and see if you qualify for a hardship program.
There are some other options too. You could try to settle the debt on your own (without using an agency) or you could even try consolidation if you have multiple accounts (keep in mind that you may have a hard time finding a consolidation loan with favorable terms if you’ve fallen behind with your regular debt payments).
Another option is a debt management plan, which encourages you to change behavior and become financially healthy, usually has a more positive impact on your credit score, and can help you pay off everything you owe.
Is debt settlement for you?
Debt settlement is a significant step to take and one you shouldn’t take lightly. While settlement can work for pretty much anyone with unsecured debt, it’s probably best suited for consumers caught between a debt management plan and bankruptcy. In other words, if you simply do not have enough income to repay your debts in full, but want to avoid a bankruptcy, settlement may be for you.
Just remember – every option comes with risks, and you need to be cautious no matter which method you pursue. Signs to watch out for (and not just when evaluating debt settlement agencies):
Over-promising. There are costs and limits to every available debt-repayment service. If something sounds too good to be true, it usually is.
Front-loaded fees. There may be fees associated with setting up a repayment plan, but you should be wary of any company that wants the majority of your money upfront, before any service has been rendered.
Pushy, aggressive salespeople. Legitimate agencies should never pressure you into making a decision you’re not ready to make. If you feel someone is coming on too strong, don’t be afraid to walk away and review other options.
Finally, keep in mind that a settlement may solve your immediate issues with debt, but it doesn’t address the cause of those issues, nor does it prevent you from running into similar issues in the future. If issues with spending or budgeting have brought you to this point, consider speaking with a certified debt and budget counselor. Counseling is free and may help you develop the financial tools and knowledge necessary to prevent future setbacks.
This article was updated in April 2018.
Neither debt settlement or debt management companies provide accurate advice to debt ridden seniors. Nearly half of seniors over 65 have incomes within 200% of the poverty line. They retire owing more debt than ever before. In my experience seniors are never told their retirement income is protected by federal law and it doesn’t need to be used to pay old debt a senior can’t afford. Many end up paying old debt they can’t afford ending up in utter poverty.
Hi Eric! Thanks for sharing!
A lot of good info there – that post is a doozy! DIY debt settlement seems to be a much better option. At least you can start paying back your creditors right away as negotiated and you have control and no fees like a debt relief company charge.
I be a-tweeting this a-one 😉
How do credit relief companies get my information and even know what my debt is? Thank you
Great question–if the company isn’t affiliated with your original creditor, I’m not sure how they would access this information (specific account details, etc.).
Hi there! Great post. I really liked the infographic about debt settlement pros and cons. It really explains it a lot better. Thanks for sharing.
Glad it was helpful, Darren. Thanks for stopping by and commenting!
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and finally got the courage to go ahead and give you a shout out from Humble Texas!
Just wanted to tell you keep up the great job!
My wife and I moved from our home town on Saint Simons Island, GA 31522 after losing everything in the real estate crash beginning in 2008. I went back to school to retrain but was misled and now owe a substantial student loan and was then went to work for $10.50 an hour until they cut the budget and my hours out. I went on early social security while I looked for a job in the much lower area where we had moved. My wife also lost her job when the company she worked for went bankrupt. When we moved we were sold a mobile home with tons of promises that were all lies and ended up being financed by the in-house finance company at twice what we were promised. The sales person tried to get us to lie on the credit application and when we refused she apparently lied for us and forged our names, lied about our jobs, assets and I don’t know what all else. There were 5 supposedly ” Final closings” but we never got a copy of anything. They refused to stop the deal and switched us to an inferior product than what we had been told we were buying at twice the cost and payments. I have complained to everybody I can find who will listen but we are so far in the hole and in debt that we can not stay current on anything. More lies and now threats of foreclosure. We even fell for fake credit help from 3 different agencies that were supposed to help us but instead just ripped us off and did nothing. I am disabled now and 64 years old. My wife found a job as a secretary that pays about $20,000 per year but 1/2 of that is going to Medical insurance that came after I fell and ruined my back and ran up thousands of dollars in medical bills. We have sold everything that we have to sell of any value and our bank went bankrupt and the new bank seized what little bit of money we had left. The sales lady knew all of this so she committed mortgage fraud, misrepresentation of the truth, bait and switch of the product and lied about everything. The in-house lender lies about everything too and refuses to help in any way, and is engaging in predatory lending practices at the very least. We cannot afford a good local attorney and my wife is having a nervous breakdown over all of this. She is finally seeing a psychiatrist and on medication for depression, anxiety and suicidal ideations. Me too, except for the suicidal aspect. But that is way too expensive too. So who gets paid first. But we have to survive this and do something differently. We badly need help. Please. We have been so badly ripped off that this is way more than our little temporary money problem. They are outright criminals. Where can we go for help, please?
I sent your contact info to our team so that someone can reach out to you. That said, you’re also welcome to give us a call at 877-877-1995, and someone can help you!