Is debt settlement a good idea? How to tell if it’s right for you

Debt settlement is a risky way to reduce your debts. It will help you avoid bankruptcy, but depending on the settlement amount, you may be stuck paying extra taxes. Many debt settlement companies charge high fees and take years to negotiate your debts fully.

Consider alternatives and compare all your options before signing up for debt settlement.

How to decide if debt settlement is right for you

Debt settlement involves negotiating with your creditors to reduce the debt on each account. It is a lengthy and expensive process, and for some, it can lead to big negative repercussions. A huge hit to your credit and a lawsuit are not out of the realm of possibility.

This makes it a last resort option when you’re also considering bankruptcy. Ideally, you should consider alternatives and try to increase your income or reduce your debts before hiring a debt settlement company.

If you have exhausted your other options, you may want to consider debt settlement. Suppose you haven’t made headway negotiating or working with a credit counselor. In that case, a debt settlement company may be able to help you restructure your debts and make monthly payments more affordable. Just be aware of the many drawbacks of choosing this route.

Benefits of debt settlement

Working with a debt settlement company typically has more drawbacks than benefits, but there are some good reasons to pursue debt settlement. Most importantly, a debt settlement company handles negotiation on your behalf. This will save you time, and for some people, it may be worth the added expense.

The goal of debt settlement is to lower your total debt and avoid bankruptcy. A debt settlement company can help you do that.

Drawbacks of debt settlement

For many, debt settlement is not the right solution. It has several cons, so even if your debt ends up being reduced, you’ll still be stuck with a huge bill that can be harmful to your finances.

• High fees. Legit debt settlement companies won’t charge upfront fees, but they will charge you a percentage of the amount of debt. Whether it’s your starting amount or the amount the company reduces depends on the terms of your contract.
• Negative impact on credit. Many debt settlement companies advise you to stop paying your creditors. This puts you in default, which means late fees and negative marks on your credit report.
• Creditors may refuse to negotiate. Your creditor may not be willing to negotiate with a third party. And if it won’t negotiate, the company can’t settle your debt. That means you could be missing payments and racking up fees for no benefit.
• Savings on debt is taxable. If the debt settlement company can reduce a $5,000 debt to a $2,500 debt, you are responsible for paying income tax on the forgiven amount. However, this is also true if you negotiate the debt by yourself.
• Lawsuits are possible. Depending on how long you go without paying your debts and how the negotiation process goes, a creditor could file a lawsuit against you. This means more fees and, potentially, wage garnishment.

How to choose a debt settlement company

You will need to compare options before you select a debt settlement company. Every company has its own fee schedule and settlement timeline. However, you should only consider companies that are licensed by your state and are upfront about costs.

Once you have three or so debt settlement companies chosen, request a quote from each. A settlement company should never guarantee that it can get you out of debt or reduce your debt by a certain amount, but it will likely provide examples from previous clients. The quote you receive should break down the potential timeline, all fees and risks of debt settlement.

Ask for a detailed explanation of the process as well. Two to four years is common, and you will likely need to have an account through a third party to deposit the payments you are making toward your debt. If the debt settlement company isn’t willing to work with you or offer satisfactory explanations for each fee, move on. There are plenty of other, more legit companies that will.

Alternatives to debt settlement

Debt settlement can be done without a debt settlement company. Ultimately, an alternative — like negotiating yourself, consolidating debt or using a credit counselor — may save you money and help improve your credit score.

Nonprofit credit counseling

A good starting point might be nonprofit credit counseling. Reputable nonprofit credit counselors, such as Money Management International and other agencies accredited by the National Foundation for Credit Counseling, will work with you and your creditors to devise a plan. These debt management plans often last three to five years.

They typically involve lower interest rates and a single monthly payment. Participants are often required to close the affected credit cards, which speaks to the behavioral modifications that should be incorporated into a successful debt payoff strategy.

DIY negotiation

In addition to credit counseling, you can negotiate your debts by yourself. If you are experiencing financial hardship, many creditors will have options to defer — or potentially reduce — your debt. Reach out to your creditors’ customer service team, explain your situation and see if you can lower your debt. Even if your creditor cannot settle for a lower amount, it might be willing to defer payments or rework the terms you initially signed.

Personal loans

The personal loan rates you qualify for will depend on your debt-to-income (DTI) ratio, your credit score and other aspects of your finances. Using a loan to consolidate your debt will not reduce the total amount you owe, but it could make it easier to make payments. And if you are able to qualify for a lower average interest rate across your debts, you may wind up paying less overall.

Balance transfer credit cards

Likewise, a balance transfer credit card won’t reduce the total amount you owe. But if you can qualify for a 0 percent introductory rate, you could make a lot of headway paying down your debt without worrying about interest. Interest rates will be higher than a personal loan once the introductory period ends, but as long as it is lower than your average rate across your current debts, it should still help you save money.