How to tell if debt settlement is a good idea for you
Credit settlement may help you eliminate credit card balances for less than you owe. However, this debt relief method has several risks.
If you’re one of the millions of Americans struggling with overwhelming credit card balances, you may wonder if debt settlement is a good idea for you. You or debt settlement companies can negotiate with your creditors so that you pay less than what you originally owed.
While debt settlement may free you from a never-ending cycle of minimum payments, it will negatively affect your credit score, and by the time you can consider debt settlement, your credit score will already be in bad shape. The process can also be costly and carries several long-term risks.
Before settling debt, it’s important to learn how debt settlement works and some alternatives to decide if this debt relief strategy is right for you.
How debt settlement works
Debt settlement is when you or a debt settlement company negotiate with creditors to pay off your balance for less than you owe.
A creditor generally won’t want to settle with you unless you are already enough behind in payments that they think they won’t get paid otherwise. You’ll also need enough money to offer a lump-sum payment in exchange for the rest of the debt being discharged.
The process may also be effective in helping you avoid bankruptcy, although debt settlement may be worse than bankruptcy when it comes to your long-term financial health.
Creditors are under no obligation to settle debts. They can decline to negotiate or send you to a collection agency before negotiations are completed. You could try to settle your debt and not have the outcome you were hoping for, leaving you with more debt from late fees and interest rates and a worse credit score from missed payments.
Debt settlement pros and cons
To determine if this payoff method is bad for your credit record or the right path toward financial peace of mind, consider the following pros and cons of debt settlement.
Pros
- Avoid bankruptcy: Note that some experts consider debt settlement to be worse than bankruptcy. Debt settlement can also stay on your credit for seven years, and you’ll likely have the penalties of missed payments and charged-off debt. However, if avoiding bankruptcy is your biggest goal (like if you want to avoid it because your chosen career field disqualifies people who have filed for bankruptcy or you have filed too recently to file again), debt settlement may help you do that.
- May help you avoid collections: Creditors can sometimes be easier to deal with than debt collectors. If the creditor is cooperative, you may be able to negotiate a settlement with them instead of being sent to collections.
- Potential debt reduction: Debt settlement may reduce the total amount you owe, providing relief from debt burdens. However, the fees of settlement and late fees can sometimes inflate your debt, making the savings less impactful overall.
Cons
- Fees and costs: Debt settlement companies may charge fees for their services, which can add to your overall debt burden. Creditors may also charge additional fees beyond the previous late fees and interest rates as part of debt settlement negotiations.
- Inflated debt: Because negotiation can take some time, you could end up with more debt than you started with. Negotiation doesn’t pause late fees or interest rates. Those often keep adding up, and the long process can make the situation worse.
- Negative credit score impact: Debt settlement can negatively impact your credit score, as settled accounts may be reported as “settled” or “charged-off.” A debt settlement may remain on your credit report for up to seven years.
- Not all types of debt are eligible: Some types of debt, like mortgages are car loans, can’t be settled. In those cases, the home will be foreclosed, or the car will be repossessed.
- Requires creditor cooperation: Many lenders are unwilling to settle current debts and will only consider older, past-due debts for debt settlement negotiations. In addition, there is no guarantee that creditors will agree to settle your debts for less than the full amount owed, making negotiations uncertain. They could also expect a higher lump-sum payment than you can afford.
- Slow process: Negotiating takes time. Every month you don’t make your payments, your credit score will likely suffer, and you’ll likely have more late fees. If you’re paying a debt relief company to keep funds in escrow while you work toward a lump sum, you could be dealing with the debt for a year or more without knowing if debt settlement will work in the end.
- Tax implications: The IRS counts the forgiven portion of your debt as taxable income, which may result in additional tax liabilities.
How to settle debt
If you decide you want to try debt settlement, you generally have two options. You can hire a debt settlement company or try to negotiate yourself.
Hire a debt settlement company
Debt settlement companies, sometimes also called debt relief companies, have the expertise and resources to help you with this process.
When you use a debt settlement service, instead of paying your monthly bills, you will put money in an escrow account that the settlement company manages. The company will then use the money in the account to negotiate a lower payoff amount. Usually, you have to be in debt a certain amount and already be behind in payments to start working with a company.
You’ll continue to rack up late fees and interest and see your credit score decrease while you’re paying the debt relief company to build up that lump sum for negotiations.
Settle the debt yourself
Do-it-yourself debt settlement negotiation involves directly communicating with your creditors to reach a mutually agreeable settlement without the involvement of a third-party debt settlement company. This can be a cost-effective option for debt relief. However, it is important to approach the process carefully and be prepared for potential challenges along the way.
Consider seeking guidance from reputable financial resources or consumer advocacy organizations to help navigate the negotiation process effectively. Additionally, be aware of your rights as a consumer under applicable debt collection laws and regulations to ensure that your interests are protected throughout the negotiation process.
Alternatives to debt settlement
It’s possible to get debt relief without using a debt settlement company. Here are some alternative debt relief options.
Nonprofit credit counseling
Nonprofit credit counseling agencies, such as the ones accredited by the National Foundation for Credit Counseling (NFCC), may help you manage debt effectively.
Credit counseling services offer financial education, budgeting assistance and debt management plans to help you repay debts in full over time.
Debt management plans may span three to five years. They typically involve lower interest rates and a single monthly payment. You may be advised to make other adjustments to pay off your debt successfully, such as closing the relevant credit cards so you aren’t tempted to spend more on them.
If you’re considering whether to use a debt settlement company, it may be worth contacting a nonprofit counseling agency for advice.
“It matters that you receive the best possible guidance,” said Bruce McClary, a senior vice president at the National Foundation for Credit Counseling. McClary has more than 25 years of experience in the credit counseling industry. “The education and guidance tailored to address your specific needs is what makes nonprofit credit counseling unique among others offering debt relief.”
Debt consolidation
Debt consolidation is a strategy that involves combining multiple debts into a single loan with a lower interest rate. Unlike debt settlement, consolidation requires full repayment of the outstanding balance.
With debt consolidation, you take out a new loan or open a new line of credit to pay off your debts. This can include credit cards, personal loans, medical bills and other types of unsecured debt. Consolidation simplifies your repayment process so you’re only dealing with a single creditor and making one monthly payment instead of multiple payments to various creditors.
Balance transfer credit cards can be an effective tool for saving money on interest and consolidating your debt. You may be able to consolidate high-interest debt onto a card with a lower or zero-interest introductory rate. Carefully evaluate the terms and conditions of the balance transfer offer and consider any associated fees.
Bankruptcy
Bankruptcy provides legal protection from creditors and offers a fresh start by discharging or restructuring your debts. However, it can have long-lasting consequences for your credit scores and financial standing.
That said, bankruptcy has some advantages compared to debt settlement. For example, while you try to settle a debt, your creditors may still sue you for nonpayment. In addition, you may have to pay fees and interest charges that can increase the amount you owe.
With bankruptcy, you’re protected from creditor lawsuits. In addition, bankruptcy allows you to start rebuilding your credit sooner than debt settlement options.
Like with debt settlement, the decision to file for bankruptcy should not be entered lightly. Consider talking to a bankruptcy attorney to make sure it’s the right choice.
How to choose a debt settlement company
Choosing a debt settlement company is a crucial decision that can significantly impact your financial future.
If you decide to pursue debt settlement over other alternatives, research your options to identify reputable debt settlement companies with a track record of success and positive client reviews. Start by checking online reviews, consumer advocacy websites and other relevant resources to gather insights into the company’s reputation and credibility.
Here are a few key features of debt settlement companies to consider during your research.
Accreditation and certification
Accreditation signifies that the company adheres to industry best practices and ethical standards. Look for debt settlement companies accredited by recognized industry organizations, such as the American Fair Credit Council (AFCC) or the International Association of Professional Debt Arbitrators (IAPDA).
Transparency and disclosure
Choose a debt settlement company that provides clear and transparent information about its fees, services and the debt relief process. Debt settlement outcomes can vary depending on individual circumstances and creditor cooperation. Avoid companies that make promises or guarantee specific results.
Legal compliance
Ensure that the debt settlement company complies with state and federal regulations governing debt settlement practices. Verify that the company is licensed to operate in your state and understands relevant laws.
Fee structure
Understand the fee structure of the debt settlement company, including any upfront costs, monthly service charges and contingency fees based on the amount of debt settled.
Reputable companies typically charge fees based on performance, meaning they only collect payment after successfully negotiating and settling your debts.
Communication and support
Evaluate the company’s communication channels and level of support provided to clients throughout the debt settlement process. Choose a company that offers personalized guidance and regular updates on the progress of your settlements. Effective communication is essential for addressing concerns and ensuring a smooth experience.
Debt settlement scams: Red flags to avoid
Unfortunately, some debt settlement companies are less credible than others. Here are some warning signs to look out for:
- The company requires you to pay upfront fees before settling your debts.
- It advertises a “government program” that can help you achieve debt relief.
- The organization uses robocalls to contact you.
- It guarantees it can eliminate your debt.
- Its representatives advise you to stop communicating with your creditors.
Is debt settlement right for you?
Deciding whether debt relief is a good idea takes careful consideration of your financial circumstances, goals and risk tolerance. Here are some questions to ask yourself:
- Do you have levels of unsecured debt, like credit card debt or medical bills, that are higher than you can realistically pay off?
- Have you been unable to keep up with minimum payments?
- Are the debt settlement alternatives unavailable to you?
You may be a good candidate for debt settlement if you answered yes to at least one of these.
The bottom line
Debt settlement may offer a lifeline for individuals drowning in consumer debt by securing a lower payout than what they owe. However, there are drawbacks to debt settlement: It may negatively affect your credit score for years, it can be costly and there’s no guarantee that the service will work.
By carefully considering the pros and cons of debt settlement, you can determine whether this is a good option for your situation.
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