Debt Settlement: For Beginners How It Works and If It’s Worth It.

What is Debt Settlement?

Debt settlement is a process whereby a debtor and creditor agree to settle a debt for an amount that is less than the full amount owed. This can be done through negotiation between the parties or through a third-party mediator.

In some cases, creditors may be willing to accept less than the full amount owed in order to avoid incurring further legal or collection costs. For consumers, debt settlement can be an effective way to reduce the total amount of debt owed.

However, while debt settlement can benefit both parties, it is important to understand the risks involved before entering into any agreement.

How Does Debt Settlement Work?

When you settle a debt, you agree to pay the creditor an amount less than what you actually owe. For example, let’s say you owe $10,000 on a credit card balance. 

If you settle the debt for $7,000, the credit card company will agree to accept that as payment in full and will forgive the remaining $3,000.

There are two primary ways that debt settlement can work. The first is through direct negotiation between the debtor and creditor. This typically occurs when the debtor is facing financial hardship and is unable to make the total monthly payments owed. 

In these cases, the debtor may request a “settlement” with the creditor in which they agree to pay a lump sum that is less than the total amount owed.

The second way debt settlement can work is by using a third-party company. These companies will typically charge the debtor a fee for their services. The company will then attempt to negotiate a settlement on the debtor’s behalf.

Debt settlement is an option that can be used for various types of debt, including credit card debt, medical bills, and personal loans.

What is a debt settlement company?

A debt settlement company is a for-profit business that offers to negotiate with your creditors on your behalf to settle your debts for a lower payoff amount.

To make money, a debt settlement company will charge you a fee. This fee can be a percentage of the total debt they settle(15% to 25%) or a monthly service fee.

The company will then attempt to negotiate a settlement on your behalf with your creditors. In some cases, they will also agree to make payments to the creditor on your behalf in an effort to reach a settlement.

The Pros of Debt Settlement

Reduced overall debt: One of the most obvious benefits of debt settlement is that it can reduce your overall debt burden. When you settle a debt, you will typically only be responsible for paying a portion of the debt you originally owed.

One lump-sum payment: Once you’ve reached a settlement, you’ll make one lump-sum payment to the debt settlement company. This can be easier to manage than making multiple payments each month.

Potential for a reduced interest rate: In some cases, creditors may agree to reduce the interest rate on your debt as part of the settlement agreement. This can save you money over the life of your loan.

Lower monthly payments: Debt settlement can lower your monthly payment in two ways. First, the debt settlement company may be able to negotiate a lower interest rate on your behalf. Second, the debt settlement company may be able to negotiate a lower monthly payment amount. This can provide some much-needed relief to cash-strapped consumers.

Evading bankruptcy: Debt settlement is an alternative to bankruptcy. By negotiating with your creditors to settle your debts for a lower payoff amount, you can avoid having to file for bankruptcy. Unlike bankruptcy, debt settlement does not have a much negative impact on your credit score.

Evading Lawsuit: Debt settlement can also help you avoid a lawsuit. When you owe money to creditors, they have the legal right to sue you and garnish your wages. If you are facing a lawsuit, debt settlement may be able to help by negotiating with your creditor to settle the debt out of court.

Relief from creditor harassment: One of the main reasons people look into debt settlement is to stop the constant phone calls and letters from creditors. A debt settlement company will handle all communication with your creditors. This can be a great relief if you’ve been dealing with the stress of creditor harassment.

The Cons of Debt Settlement

There are also some potential drawbacks to debt settlement that you should be aware of:

Debt settlement fees: Most debt settlement companies will charge you a percentage of the debt they settle for you. These fees can range from 15% to 25% and are typically paid out of the money you save by settling your debts.

Your creditor may not agree to settle:  While some creditors are open to negotiating a settlement, others may refuse. Creditors are not mandated to agree to settle your debt. If they disagree, you’ll still be responsible for repaying the total amount of your debt.

You could end up paying more: It can take several months – or even years – to save up enough money to settle your debt, and during that time, interest and late fees will continue to accrue, making the total amount you owe even higher. And if you’re unable to make the monthly payments required to save up for a settlement, you may default on your debt.

You could end up in default: If you stop making payments on your debt to save up for a settlement, you will technically be in default. This can lead to wage garnishment, legal action, and damage to your credit score.

You may have to pay taxes on the forgiven debt: Depending on the circumstances, the IRS could classify the forgiven debt as income, which means you would be responsible for paying taxes on it. 

It can negatively impact your credit score: Any debt settlement, whether through a debt settlement company or DIY, will negatively impact your credit score.

This is because when you settle debt, the creditor agrees to accept less than what is owed – which is then reported to the credit bureaus as “settled for less than full balance.” This will stay on your credit report for up to seven years and make it difficult to obtain new credit.

Additionally, your creditors may also report the missed payments leading up to the settlement, further damaging your credit score.

Who qualifies for debt settlement?

According to the Federal Reserve Board, 7.1% of credit card debts were “seriously delinquent” in the fourth quarter of 2016. This means that the account was at least 90 behind on payments, making the cardholder a prime candidate for debt settlement.

To qualify for debt settlement, the debtor must be

• Experiencing financial hardship, making it challenging to keep up with minimum payments
• Be delinquent on their payments
• Be willing to close all accounts included in the settlement
• The debtor also needs to save up to make a lump-sum payment to the creditor.

Once both parties have agreed to enter into debt settlement negotiations, they will work together to decide on the amount that will be paid.

What types of debt are eligible for debt settlement?

Debt settlement companies typically target unsecured debt, such as credit card debt, medical bills, and personal loans. This type of debt is not backed by collateral, so creditors are least likely to recover through other means, such as wage garnishment or a lawsuit.

Some of the most common types of unsecured debt that are eligible for settlement include:

• Credit card debt
• Medical bills
• Utility bills
• Personal loans
• Business loans
• Department store cards

Some debt settlement companies also target secured debts such as mortgages and car loans, but this is less common.

Alternatives to debt settlement

If you’re struggling to make payments on your debts, there are several other options to consider without resorting to debt settlement. These include:

Debt management program

A debt management program is a plan that helps you repay your debts. The program works with your creditors to lower your interest rates and monthly payments. This can help you repay your debt more quickly and affordably.

A debt management program typically lasts for three to five years. During this time, you make monthly payments to the program instead of your creditors.

The program then uses these payments to pay off your debts, starting with the debts with the highest interest rates. If you’re struggling to repay your debts, a debt management program can be an effective way to get back on track.

However, it’s essential to understand that a debt management program is not a magic solution. You’ll still need to be disciplined in your spending and saving habits if you want to get out of debt for good.

Debt consolidation loan.

A debt consolidation loan is a personal loan that can be used to pay off your existing debts. The benefit of a debt consolidation loan is that it usually has a lower interest rate than the interest rates on your individual debts. 

This can help you save money on interest charges and may help you pay off your debt faster. 

Additionally, consolidating your debts into one monthly payment can make it easier to keep track of your finances and stay on top of your repayments.

Balance transfer credit card.

Another option for consolidating your debts is to transfer the balances of your high-interest credit cards to a low-interest balance transfer credit card.

Balance transfer credit cards usually have an introductory period during which you can enjoy 0% interest on transferred balances. 

This can help you save money on interest charges and allow you to focus on paying off your debt faster.

Nonprofit credit counseling.

If you’re struggling to manage your debts, you may consider seeking help from a nonprofit credit counseling agency. 

Credit counselors can help you develop a budget and create a debt repayment plan. 

They can also negotiate with your creditors on your behalf to try to get them to lower your interest rates or waive certain fees.

Is debt settlement worth it?

For some people, debt settlement can be a good option. If you can negotiate a settlement that’s lower than what you owe, it can help you save money and get out of debt faster.

Specifically, debt settlement may be a good option if:

• You’re struggling to make your minimum monthly payments
• Your debts are significantly past due
• You’re unable to find a solution with your creditors
• You can’t afford to make the full monthly payment on your debts

On the other hand, there are some drawbacks to debt settlement that you should be aware of.

For one, it will negatively impact your credit score. Additionally, you may have to pay taxes on the forgiven debt, and you could end up owing more money if your creditors don’t agree to the settlement terms.

Before you decide to pursue debt settlement, you must understand all potential risks and rewards. Work with a qualified financial professional to explore your options and make the best decision for your unique situation.

However, if you finally decide to go for it, keep these few things in mind.

Review your finances. You’ll need to clearly understand your current financial situation before deciding if debt settlement is right for you. This includes knowing how much debt you have, the kind of debt, and your current income and expenses.

You can get a good idea of your current financial situation by reviewing your credit report and creating a budget.

1. Pick the righ debt settlement company.

There are many debt settlement companies in the US. Some are better than others. Do your research before you choose one.

It is preferable you work with a company that is a member of the American Fair Credit Council (AFCC) or the International Association of Professional Debt Arbitrators (IAPDA).

These two organizations have high standards for their members. They also require their members to disclose important information to the consumer.

2. Be cautious. 

Not all debt settlement companies are legitimate. Some may charge high fees or promise results they can’t deliver.

If you decide to work with a debt settlement company, be cautious. Make sure you understand the terms of any agreement before signing anything.

Beware of companies that:

• charge upfront fees
• guarantee they can make your debt go away.
• require you to stop communicating with your creditors

If a company promises any of these things, it’s likely a scam. The best way to avoid getting scammed is to do your research. Check with the Better Business Bureau to see if there are any complaints against the company you’re considering.

3. Ask about additional costs. 

Legitimate debt settlement companies will only charge you after settling your debt. And even then, the fee should only be a certain percentage of the total debt that was settled.

You should also find out if there are any other costs involved, such as set-up fees or monthly maintenance fees. You want to make sure that you understand all of the fees before signing up with a debt settlement company.

4. Select a debt settlement company

Once you’ve checked out a few companies, it’s time to select the one you want to work with. Be sure to ask about the company’s experience, settlement success rate, and fees.

You should also find out how long the process will take. It’s important to know that debt settlement is not a quick fix. It can take several months or even years to settle your debt.

5. Get everything in writing.

Once you’ve chosen a company, ensure that you get everything in writing. This includes the payment schedule, the terms of the agreement, and the company’s fees.

You should also find out what happens if you can’t make a payment or the debt settlement company doesn’t deliver on its promises.

Getting everything in writing will help protect you if there are any problems down the road.

Will debt settlement negatively affect your credit score?

Yes, debt settlement will likely have a negative impact on your credit score. When you settle a debt, it will show up on your credit report as “settled for less than the full amount.” This designation can stay on your credit report for up to seven years and likely result in a lower credit score.

However, the impact of debt settlement on your credit score will depend on some factors, including the amount of the debt, how much you settle for, and your credit history prior to settlement.

Debt settlement company vs. DIY

There are many factors to consider when deciding whether to use a debt settlement company or try to settle your debts yourself. One important consideration is the amount of debt you owe. If you only have a few thousand dollars in debt, it may be more feasible to try to negotiate with your creditors yourself.

However, if you owe tens of thousands of dollars, a debt settlement company may be better. Another critical consideration is the type of debt you have. Credit card debt is typically easier to settle than student loan debt, for example.

Finally, you should also think about your financial situation and whether you have the time and patience to negotiate with creditors. If you’re struggling to make ends meet, a debt settlement company can provide much-needed relief.

The bottom line

So, is debt settlement worth it? It depends on your financial situation. If you’re struggling to keep up with your payments and think debt settlement could help you get back on track, it might be a good option.

Keep in mind, though, that there are both pros and cons to this type of debt relief solution, so do your research before making a decision.