The average American has a little over $90,000 in consumer debt, though some people owe much more than that. For those who are in desperate need of debt relief, debt settlement may be the way to go. Debt settlement is the process of reducing the balance of existing debts to a lower total amount. It’s a way for people to get rid of debt, save money, and regain control over their finances.
Still, debt settlement isn’t for everyone. Before trying to settle any debts, it’s important to understand how it works, the risks, and what other options exist.
How Debt Settlement Works
Debt settlement is a form of debt relief. When done right, it’s one of the best ways to reduce or even eliminate debts entirely. The debt settlement process involves negotiating a settlement offer with creditors or lenders to reduce certain debts to a fraction of what they originally were.
Some people choose to handle this debt negotiation on their own, but it’s often easier with debt settlement services. A debt settlement company is a third-party, for-profit agency that negotiates with an individual’s creditors on their behalf.
The cost of debt settlement depends on a few factors, such as the types of debt and the amount owed. In some cases, debt settlement is cheaper than other debt-relief options.
To settle debt, the company will typically tell the borrower to stop making payments on their accounts. This is because most creditors and lenders will only agree to settle debts that are delinquent.
While the debt settlement company negotiates, the borrower must start making payments into an account. The money in this account is what the company will then use to pay the creditors or lenders. Only rarely will the borrower pay their lenders directly.
Any settled debts will come with new terms and conditions, which the borrower must agree to before moving forward. Once agreed, the debt is considered “settled.”
At this point in the settlement agreement, the borrower will start a payment plan for a set amount of money each month until there is no more balance on the account. In some cases, they may have to make a single, lump-sum payment for the entire balance. In others, they can make installments over a period of time. They will also pay the debt settlement company for its services.
Debt Settlement Strategies
Debt settlement is a solid option for people who need help with a substantial amount of debt. However, debt settlement strategies do come with their share of risks.
Here are the main ones:
- Damaged credit. Any account that shows up as “settled” on a credit report will hurt your credit score. Plus, since you’re not making payments during the process, your creditors will report this to the credit bureaus. Late or missed payments can impact your credit score for up to seven years. The higher your original credit score, the bigger the drop.
- Harassing calls from debt collectors. Once you default on payments, the accounts will be sent to collections. When this happens, you may start receiving calls from collection agencies.
- Lawsuits. If they consider the debt worth their while, your creditors or lenders could sue you for not making payments. This could lead to garnished wages.
- Taxes. The Internal Revenue Service (IRS) may view any debt that’s settled for less than the original amount as taxable income. This means you may have to pay taxes on the difference between what you owed and what you’re now paying.
- Additional costs. During settlement, late fees and interest will still accrue on the enrolled accounts. According to the Consumer Financial Protection Bureau, these penalties and fees could cancel out any savings you may have otherwise had.
The debt settlement process is complicated and takes between two and four years. Because creditors and lenders are not obliged to accept it, it does not always work.
Some lenders, such as Chase Bank, will not work with debt settlement companies at all. Instead, they’ll only work with the borrower or a nonprofit credit counseling agency.
However, if all goes well, debt settlement could save you a lot of money. In fact, the average consumer sees a total debt reduction of 33.2% due to debt settlement.
What Percentage Should I Offer to Settle Debt?
Most debt settlement companies charge between 15% and 25% of the enrolled debt (any debt you enroll into the program). Say, for example, you enroll $30,000 in the program. The company will charge based on that amount, not the amount you owe after settlement.
A few debt settlement companies charge a flat fee for their services, but this isn’t that common. Some will charge based on the end result or the amount saved instead of the amount enrolled.
Whatever their payment system is, these companies cannot charge anything until after the process is complete, according to the Federal Trade Commission (FTC).
If you want to settle your debts without a third-party agency, be prepared to negotiate. Start by explaining your situation to your creditors and lenders about why you need the debts settled. They may be willing to work with you.
Ask to settle the debts for a lower percentage than you’re willing to pay. Generally, you should try to settle debts for around 30% of what you owe. If the lender or creditor suggests 50% or above, try to settle other debts instead. Upon reaching an agreement, get the new terms and amounts in writing.
Debt Settlement vs. Bankruptcy
Bankruptcy is another way to get rid of debt, but it’s not for everyone.
A Chapter 7 bankruptcy can eliminate most outstanding debts. Some of the forgiven debts include personal loans, credit card debt and medical debt. Once filed, the court will put an automatic stay in place. This keeps most debt collectors from pestering you with collection calls and prevents creditors from filing any lawsuits against you.
Bankruptcy usually takes around six months to complete, making it much faster than debt settlement. Since it’s faster, it’s also possible to start rebuilding credit sooner than with debt settlement.
However, not everyone is eligible for bankruptcy. To qualify, you must:
- Not have filed for a Chapter 7 in the past eight years or a Chapter 13 in the past six years.
- Prove your income is below a certain threshold for your state.
- Complete a credit counseling course within six months.
Besides this, there are a few other disadvantages to filing for bankruptcy.
For one thing, bankruptcy attorneys often charge upfront and cost between $1,000 and $3,000, on average. For another, you must liquidate any non-exempt assets to pay off debts. This includes things like cash, inherited assets, stocks and bonds, and vacation properties.
On top of that, a Chapter 7 bankruptcy can remain on your credit report for up to 10 years. It’s also a matter of public record, so it may limit other opportunities for you in the future. This includes future employment since many companies use bankruptcy as a qualifying factor for employment.
With debt settlement, anyone who can demonstrate qualifying financial hardship, such as a lost job, may be eligible. When it works as intended, the individual ends up with less debt and can even save money. Plus, on the creditors’ side, they get more money than they might have if the borrower filed for bankruptcy instead.
To learn more about the differences between debt settlement and bankruptcy, watch this video:
Debt Settlement vs. Making the Minimum Monthly Payments
Debt settlement may take several years but paying off debts by making the minimum monthly payments can take decades. This is due to a few factors, including:
- Interest rate on the account
- Starting amount of debt
- If you miss or are late on any payments (late fees add up)
Although paying the account minimums may work for a while, this isn’t a good long-term strategy. By only paying the minimums, you’re going to have to pay much more in interest over time. This ultimately keeps you in debt longer and makes it harder to save money.
Plus, most types of debts have compounding interest. Compounding interest is interest that’s based on the current principal balance and the previously accrued interest on the account. Depending on the account, it can build up daily, monthly, or yearly.
The longer your accounts carry a balance, the higher the compounding interest will be. That’s why it’s better to pay off these debts as soon as possible. Plus, if you miss even one payment, the interest will compound, thus increasing the total amount you owe.
Making only the minimum payments could also hurt your credit score. For one thing, credit utilization accounts for 30% of your FICO Score. Payment history also has a major impact on your credit. Even one missed or late payment could cause a noticeable drop.
Ultimately, paying the minimum monthly balance each month is more profitable to your creditors than it is to you.
Debt Settlement Company vs. Credit Counseling
Credit counseling is a low-cost or free service offered by government and nonprofit agencies. Some credit card companies also partner with and help fund these agencies.
These agencies offer many services, including debt management plans (DMPs). Debt management plans are a good way to reduce the interest rate on existing accounts. This makes it easier to pay off the principal balance on those accounts and get out of debt.
Credit counseling is best for those who:
- Owe between $2,500 and $15,000 in unsecured debt.
- Need to reduce their interest rates so they can make their monthly payments and pay down debt faster.
- Want to pay off debt without defaulting on payments or impacting their credit score.
- Would benefit from things like late fee waivers.
- Seek other assistance such as budgeting, credit management, and financial counseling.
Not everyone qualifies for credit counseling, even if they’re facing a proven, significant financial hardship. However, credit counseling is typically much more affordable than debt settlement. You may end up still having to pay the full amount of your debts, however.
Debt settlement, meanwhile, is better for people who owe $15,000+ in debt and need to lower their total principal balance rather than their interest rate. Like credit counseling agencies, a legitimate debt settlement company will also offer other financial resources and counseling.
Debt Settlement vs. Debt Consolidation
Debt consolidation is the process of taking multiple debts and combining them into one lower-interest account. With debt consolidation, you have to pay a fixed monthly payment once a month, rather than juggle multiple monthly payments. This makes it easier to manage the debt.
Many private lenders, banks, and credit unions offer debt consolidation loans. However, you’ll need a good credit score to qualify for the best rates.
Like debt settlement, debt consolidation is usually best if you have a lot of consumer debt. This includes things like medical bills, personal loans, credit card debt, or student loans. It also helps those who need to get a handle on their debts and start paying them down.
Unlike debt settlement, debt consolidation doesn’t have as big of an impact on your credit score. It’s also usually less expensive. However, depending on the loan terms and your ability to make payments, it could still take years to pay off the new loan.
Other Options to Manage Debt
Peer-to-peer lending is a type of lending that does not require a financial institution. Instead, a borrower and an investor work together to establish the borrowing limit and terms.
With peer-to-peer lending, even borrowers with a lower credit score may still qualify for funding. In most cases, the approval and funding process usually only takes a few days.
Just like with traditional loans, peer-to-peer loans often come with origination fees, late penalties, and their own interest rates. Some investors may charge higher interest, especially to those with a lower credit score. Before agreeing to anything, make sure to read through the loan terms carefully.
Balance Transfer Credit Cards
The purpose of a balance transfer credit card is to move debt from a high-interest credit card to a low-interest credit card. Some balance transfer cards have an introductory period with 0% APR. This makes it easier to pay off the debt without having to worry about interest.
Before choosing a balance transfer credit card, here are some things to consider:
- The low or 0% APR introductory period usually lasts between six and 21 months.
- Not all credit cards allow balance transfers.
- Some cards have a balance transfer fee averaging out at 4% of the amount transferred.
- The amount you can transfer depends on the new card’s limit and other terms.
- Balance transfer cards usually require a 690 FICO Score or higher to qualify.
- Some balance transfer cards come with annual or origination fees.
- Typically, you can’t transfer the balance of one credit card to another one from the same credit card issuer.
- If you don’t pay the balance in full before the introductory period ends, you will have to pay interest.
Balance transfer cards are a great option for paying down debt, especially if you have good credit. But make sure you understand the terms of the new card and pay it off before the interest kicks in.
Borrowing from Friends and Family
Borrowing from a loved one has a lot of potential benefits. For one thing, there’s usually no interest. For another, there’s often more flexibility and a longer repayment period involved.
Before going this route, write down the terms of borrowing so that everyone is on the same page. Always keep the lines of communication open as well. That way, there’s less of a chance of damaged relationships or other problems.
Debt Management Plan (DMP)
Some credit counseling agencies offer debt management plans. A Debt Management Plan is a customized financial plan based on your personal finances, including your current debts.
A credit counselor will look over your unsecured debts and create a DMP that will let you pay them off over time. Any eligible debts (usually credit cards) will be rolled into one repayment plan with a reduced interest rate. Oftentimes, this also results in a lower monthly payment. However, it also means closing the original accounts.
With a DMP, you’ll make payments to the agency rather than to your creditors. The agency may charge a small fee for setting up the plan.
Debt management plans are a good option if you need help paying off debts and don’t need to use your credit cards.
The Bottom Line
Overall, if you need help reducing how much you owe, debt settlement may be a good option. Most people who use a debt settlement company see between a 10% and 50% reduction in what they owe. After taking out the company’s fees, many people still end up saving money as a result of debt settlement.
Debt settlement can be risky and damage your credit score. However, if you’re struggling with large amounts of debt, it can provide the financial relief you need. Before choosing any form of debt relief, consider other options like debt management plans or credit counseling. That way, you can choose the one that’s right for you.
If you negotiate a debt settlement yourself, you may be able to pay down debts sooner than with a company. Keep in mind that your credit score will still be impacted since you won’t be able to make payments during the process.
Before reaching out to your creditors or lenders, make sure you know what you want. Calculate how much you can realistically afford to pay each month. Use this to help determine the percentage you’d like to settle the debt for.
Once you’ve done this, contact your creditors. Stay calm, polite, and focused on what you need. Be prepared to explain your situation to the person on the other end of the line. If they’re not accommodating, try to speak with a different representative later.
If negotiations are going well, see if you can get your accounts marked as “Paid as Agreed.” This will do the least amount of damage to your credit score. Be sure to get any changes or verbal agreements in writing. That way everyone is held accountable.
Finally, make sure you never miss any payments. If you do, this may cancel out any negotiations you’ve successfully made
A settled account will stay on your credit report up to seven years from the day it first became delinquent. If the account was never reported as delinquent, then it’ll stay on the report for seven years after it’s settled.
A debt settlement scam is an agency or individual that promises people who are burdened financially to reduce or eliminate their debts. They may also make other impossible promises like removing negative marks from your credit report or reducing interest rates.
These scams often charge upfront fees for their services, even though it’s illegal to do so, according to the FTC. Oftentimes, they also encourage the consumer to cut off all communication with their lenders or creditors. Despite what they say, most scam companies never actually reach out to your creditors at all.
Here are a few, easy ways to tell if a debt settlement company is legitimate:
The company does not charge upfront for its services.
It does not make any guarantees of settling your debt, nor does it promise to lower interest rates.
The company’s timeframe for settling debt is consistent with the industry standard, which is between two and four years.
It does not tell you to stop communicating with your creditors or lenders.
There are real customer reviews on sites like the Better Business Bureau (BBB) about the company.
The company does not have many unresolved consumer complaints online.
When in doubt, contact the CFPB or another local consumer protection agency. Ask them if there are any negative reports about the company. In some states, legitimate debt settlement companies must also be licensed, so check for that, t
Yes, but it will take some time. Usually, you’ll have to wait to make major, positive changes until after completing the debt settlement program.
To improve your credit after debt settlement, pay all your bills on time. If you need to start building credit from scratch, look for a secured credit card or store credit card. You don’t need to use the cards to build credit, but you will need to activate them. Avoid applying for too many cards at once as too many hard inquiries can temporarily hurt your credit score.
Another option is to contact your creditors about the accuracy of the derogatory marks on your credit report. If the creditor does not respond within a certain period, you can request that the credit bureau removes the mark.
If you used a debt settlement company to negotiate your debts, reach out to them as well. They may have other suggestions or resources to help you repair your credit.