Living with debt can be stressful and overwhelming, and when one’s debts are particularly substantial, it can seem as if there’s no solution in sight.
Debt settlement, a service often provided by a debt settlement professional, is among the options available for those looking to resolve debt burdens. But before taking such an approach, it’s important to fully understand what the debt settlement process involves and what you’re signing on for.
What is debt settlement?
Debt settlement is somewhat like mediation. The process often involves negotiations taking place on your behalf with lenders. Those negotiations are usually led by a debt settlement attorney or a third-party debt settlement company. Individuals engaging in the debt settlement process are ultimately seeking to reduce the amount owed to creditors.
“Debt settlement is best-suited for those consumers who are struggling to make minimum payments,” said Sean Fox, co-president of Freedom Debt Relief. “Debt settlement candidates also have generally suffered a serious financial hardship such as loss of a job, loss of a loved one, divorce or major unexpected medical expenses that makes it difficult to have any extra income to put toward debt repayment.”
Not all lenders accept settlements, however. And there are drawbacks to be aware of when using this approach to resolving debts.
How does debt settlement work?
Debt settlement can be handled in a variety of ways, including help from a third-party debt company, or a lawyer who specializes in debt resolution. You can also try to negotiate a settlement yourself, though this can be challenging if you have no experience doing so.
A debt settlement company or attorney typically contacts lenders or creditors on your behalf and work to negotiate a lower payoff amount for unsecured debt such as credit cards. This approach can’t be used for such things as mortgages or automobile loans, both of which can be foreclosed upon.
The party acting on your behalf will seek to reduce the amount you’re required to pay back. While these negotiations are taking place, it’s not unusual for the debt settlement company to require that you begin making deposits into an account. This account will be under your control but the money will be used to pay back whatever amount is settled upon as part of your payoff agreement with creditors.
Before any debt resolution deal moves forward, you must agree to the terms. You’re not obligated to move forward with any settlement deal.
“When there is a successful negotiation on an account, and a creditor has agreed to a lower amount to be paid, which is the settlement, the client needs to approve the settlement terms,” said Fox. “The payments then will be made to the creditor, per the terms. Sometimes, the settlements involve one lump-sum payment. Others may be structured settlements, which means a client pays the agreed-upon amount over time.”
Debt settlement pros and cons
There are drawbacks and even risks associated with debt settlement, including service fees, damage to your credit score and, sometimes, an unexpected tax bill.
The fees associated with debt settlement services vary depending on local state laws. However, it’s not unusual for a third-party debt settlement professional to charge between 15 percent to 25 percent of the debt being resolved. That means if you’re seeking to settle a debt of $50,000, you’ll pay a fee based on that amount, not on the final negotiated repayment amount.
It’s important to note, however, that according to rules enacted by the Federal Trade Commission (FTC) in 2010, debt negotiation companies may only charge fees after they have resolved the debt for the client, said Fox, of Freedom Debt Relief.
Damage to your credit score
Going through the settlement process and resolving debt using this approach can negatively impact your credit score.
For instance, many debt settlement companies ask that you stop making payments on your credit card during negotiations because lenders and creditors are not as likely to negotiate with a consumer who is still able to make monthly payments on their bills. Not paying bills, of course, damages your credit.
“To settle, most creditors require that an account is in a delinquent status; so, during the settlement process, an individual’s credit score will often take a hit while the accounts are in negotiation,” said debt attorney Leslie Tayne, founder of Tayne Law Group. “This means you may also be sued.”
In addition, when accounts are marked as “settled” on credit reports it can have a negative impact on your credit score, said Tayne.
Debt settlement is not as quick as you think
Debt settlement is not a quick fix, unfortunately. To begin with, you’ll need to put a significant amount of money into a settlement account. At the same time, the attorney or debt settlement company will need to work with each of your creditors to come to a resolution, and that can take years. It’s not unusual for the entire process to take as long as three to four years.
Forgiven debt is taxable
While it may be a relief to have your debt settled, and possibly for less than you originally owed, you may now be on the hook with the IRS. That’s because forgiven debt over $600 is taxable. In other words, you may have to pay taxes on the difference between what you owe and what you will be paying back.
“The IRS considers forgiven or canceled debt as income,” said Tayne.
You may owe more than when you started
When you begin the debt settlement process, the debt attorney or third-party company will often advise you to stop making payments on your debt. However, even after you stop making payments interest will still be accruing on that debt. What’s more, you may also begin racking up late fees. In the end, these charges may increase your debt to more than was originally owed.
Reduced debt, more favorable payment schedule and more
Once debt settlement negotiations are complete, collectors can no longer pester you for the money owed. And perhaps, most importantly, you can no longer be sued over the debt.
“Debt settlement reduces your debt, you pay less than you owe…and it can eventually improve your credit,” said Tayne, adding that typically you’ll have lower monthly payments as a result of debt settlement, since the amount owed is reduced. You may also be given a more favorable repayment schedule.
Improved credit score over the long-term
While it’s true that your credit score may take a hit during the debt settlement process, over the long run this approach can be beneficial because debt settlement lowers your outstanding debt and your credit card utilization rate, said Tayne.
“Individuals on a debt settlement program can usually repay their debt in one to four years,” said Tayne. “Having lower monthly payments from entering a settlement also allows an individual to get back on their feet and become financially healthy again.”
Debt consolidation versus debt settlement
Yet another approach to dealing with debt is the debt consolidation process, which typically involves rolling unsecured debt into one personal loan. Ideally the loan comes with a lower interest rate than the rate on your credit cards.
“Debt consolidation is simply moving the balance of multiple loans into one loan,” said Tayne.
This approach also has fees associated with it, but it will not damage your credit score the way debt settlement does.
“Individuals who aren’t struggling with their monthly payments and have good credit are the best candidates for consolidation,” said Tayne. “Debt consolidation can be a good idea when the interest rates on the new loan are more favorable than the current loans. It also allows turning multiple bills each month into just one bill.”
Debt settlement, on the other hand, may be a better choice for those who are struggling to make ends meet and can’t afford their monthly payments. It may also provide relief from the stress and anxiety that often comes with significant levels of debt.
The bottom line
Debt settlement is not necessarily the best approach for everyone. It’s best to weigh your unique situation and specific financial challenges and determine whether this tactic is the best choice for you over both the short- and long-term timeframes.
“Debt settlement is not a panacea and is not for everyone,” said Fox. “For some people, a personal loan, balance transfer or credit counseling could help them get out of debt. But for a consumer really struggling with minimum payments, and who has endured a financial hardship, debt settlement may be a good option.”