Debt Settlement: What it is, How it Works & If it's Worth It

Debt Settlement

Debt settlement is an agreement made between a creditor and a consumer in which the total debt balance owed is reduced and/or fees are waived, and the reduced debt amount is paid in a lump sum instead of revolving monthly.

Learn About Debt Settlement

How Debt Settlement Works

Private debt settlement companies are for-profit entities that charge a fee of 15%-25% of the debt the company is originally asked to settle, or the lower settlement amount.

When you enter into an agreement with a debt settlement company, you will be asked to stop making payments to your creditors. You will begin to make payments to the company, which go into an escrow account and include the company’s fee. Meanwhile, the company will negotiate with your creditors to settle for a lower amount. Once you’ve paid the amount the agreement is for into the escrow account, the debt settlement company will pay your creditor. This process can take 2-3 years.

Late fees, additional interest and damage to your credit score pile up as the debt settlement company negotiates, which does severe damage to your credit score. Many consumers drop out of a debt settlement agreement without settling their debts.

Debts Eligible for Debt Settlement

Most unsecured debt is eligible for debt settlement … if the creditor agrees! The creditor is under no obligation to accept a settlement proposal.

Unsecured debt includes things like credit card debt, store cards, personal loans, medical bills – any debt that isn’t tied to property that the creditor can take back.

Types of debt that are generally not eligible include:

  • Secured debt like a mortgage or car loan
  • Student loans
  • Debt incurred by your business or your self-employment work
  • Tax debt

Before entering into an agreement with a debt settlement company, be sure that the debt you want to settle, is eligible for settlement by checking the websites for the Federal Trade Commission, Consumer Financial Protection Bureau or your state’s attorney general.

Is Debt Settlement Worth It?

While debt settlement has its drawbacks, there are some financial situations that make it a good debt relief option. For instance, those who owe a large amount to one creditor may find it a good solution. If a creditor is willing to accept half of what you owe to settle a debt that you wouldn’t be able to repay, that’s an option worth considering.

But it’s important to weigh the pros and cons of debt settlement related to your situation before deciding to enter into an agreement.

Benefits of Debt Settlement

Some of the benefits of debt settlement are:

  • The balance owed is reduced, sometimes by as much as 50%
  • It’s a way to avoid bankruptcy for those who can pay the settlement amount.
  • Once the debt is paid off, debt collectors or collection agencies will stop calling.

Debt Settlement Risks

1. Fees

Many debt settlement providers charge high fees, sometimes $500-$3,000, or more. These fees are not applied to your debt – they go straight into the agency’s pocket. By the time fees and future interest is added to your total payment, much of the savings from the settlement amount could be wiped out.

2. Credit Score Reduction

Many debt settlement providers charge high fees, sometimes $500-$3,000, or more. These fees are not applied to your debt – they go straight into the agency’s pocket. By the time fees and future interest is added to your total payment, much of the savings from the settlement amount could be wiped out.

3. Tax Implications

If a creditor agrees to settle your debt in exchange for a reduced lump sum payment, you still have to pay taxes on the savings, which is considered income by the IRS. For example, if you owe a creditor $10,000 and they settle for a one-time payment of $7,500, the balance of $2,500 is considered taxable income.

The bottom line: If it sounds too good to be true, it probably is. Be smart: Don’t fall victim to misleading claims or pay money for something you may be able do yourself. And never sign anything you don’t fully understand. It’s your money – and your responsibility!

Why Work with a Debt Settlement Company?

It’s possible for a person’s debt to reach a point that they just can’t pay it off. Often there’s a good reason – a layoff or reduction in pay, big medical bills, an unexpected emergency expense. No matter what the reason, it can be difficult to get out from under overwhelming debt on your own. This is particularly true for credit card debt or other revolving debt, that never seems to decrease, even if you’re paying monthly.

Debt settlement can offer a solution, though, as you’ve already read above, it should be approached carefully. A debt settlement company can work with your creditors to accept a smaller amount than what you owed. That said, it has to be approached carefully, because working with a debt settlement company may not solve the problem and can even put you in a deeper financial hole.

Average Debt Settled by Debt Settlement Companies

Debt settlement companies charge a fee, generally 15-25% of the debt the company is settling. The American Fair Credit Council found that consumers enrolled in debt settlement ended up paying about 50% of what they initially owed on their debt, but they also paid fees that cut into their savings. The report gives an example of a debt settlement client whose $4,262 account balance was reduced to $2,115 with the settlement. So, at first it would seem she saved $2,147, the different between what she owed and what the settlement amount was. But she also paid $829 in fees to the debt settlement company, so she ended up saving $1,318.

The report found that debt settlement clients settled an average of about 50% of what was originally owed, but realized savings of about 30%.

The average debt settlement customer has debt of about $27,000, most of it credit card debt, according to the report. If you settled that at 50%, you’d pay $13,500. But the fee on the balance would be $2,025, bringing your total payment to $15,525. That’s assuming the fee is 15% on the settled balance, rather than a higher percentage. If the fee is based on the original balance, it would be $4,050, meaning you’d pay $18,000.

Look Out for Debt Settlement Scams

It can get easy for someone desperate to get out of debt to fall for a debt settlement scam. The industry has regulations designed to protect consumers, and scams can be easy to spot if you know what to look for.

The Federal Trade Commission urges those looking for a way to settle their debt to avoid the following:

  • Companies that promise they can settle credit card debt for less than what you owe, or for “pennies on the dollar.” (Since creditors aren’t obligated to do business with debt settlement companies, the company can’t guarantee this).
  • Companies that try to collect their own fees from you before setting your debt.
  • Companies that don’t explain the risks associated with their programs, such as the fact that many consumers drop out of the program without settling their debts.
  • Touts a “new government program” to bail out personal credit card debt.
  • Guarantees it can make your unsecured debt go away.
  • Tells you to stop communicating with your creditors, but doesn’t explain the serious consequences.
  • Tells you it can stop all debt collection calls and lawsuits.

The best way to avoid being ripped off is by being an educated consumer. Know what the rules are for these companies by checking the FTC website, your state attorney general’s website or local consumer protection agency. These organizations not only spell out what such companies can and can’t do, but they also list companies that consumers have complained about. You can ask your state’s attorney general office if a company you’re considering doing business with is licensed to work in your state. You can also enter the name of the company name with the word “complaints” or “scam” into a search engine, like Google.

Debt Settlement Companies: Not Transparent about Fees and Tax Liability

There are reputable debt settlement companies out there. But because there are others that aren’t,

debt settlement companies must play by certain rules in order to protect consumers. While the company won’t tell you about the risks listed above – including tax implications and the hit to your credit score – they are required to disclose certain things.

Debt Settlement Company Disclosure Requirements

Debt settlement companies are required to make certain disclosures to customers – knowing what these are may help you decide if debt settlement is the right option for you.

These disclosures have to be made before you sign up with the company.

They are:

  • Debt settlement companies must explain price and terms, including fees and any conditions on services.
  • The company must tell you how many months or years it will take before the company makes a settlement offer to each of your creditors.
  • The company must tell you how much money, or the percentage of each outstanding debt, you must save in an escrow account before it will make an offer to each creditor on your behalf.
  • If the company asks you to stop making payments to creditors, it must tell you the negative consequences, including how it affects your credit report and credit score; possible lawsuits by creditors, collections action by them, and continued fees and interest accumulation that will increase what you owe.

The debt relief company also must tell you:

  • The money you save in escrow is yours, and you are entitled to the interest earned.
  • The account administrator is not affiliated with the debt relief provider and doesn’t get referral fees.
  • You may withdraw your money any time without penalty.

DIY Debt Settlement: Negotiating Your Debt Yourself

If debt settlement still looks like the best move for you, you may want to consider doing it without going through a debt settlement company. You can negotiate directly with credit card companies and other lenders, or you can hire a lawyer to do the talking for you.

If bargaining over the phone isn’t appealing, you can always send creditors a letter explaining your situation and offer partial payment. Be sure to ask that they remove delinquent payments from your credit report.

Doing it yourself could save you thousands of dollars, though when it comes to debt settlement, it pays to remember there are no guarantees, since lenders don’t have to negotiate for money they’re owed if they don’t want to.

You might also consider DIY debt settlement if you are being sued over credit card debt. In this case, there may not be time to work with a debt settlement company. Your creditors may prefer to work out a settlement with you rather than pay the legal expenses associated with going to court. However, you must be prepared, with a good chunk of change, to pay a sizable lump sum for the settlement.

Debt Settlement Compared to Other Debt Relief Options

Debt settlement can take a few years to achieve, and that’s if your creditors agree to settle. You may find yourself making payments to the debt settlement company, just as you would for a debt consolidation loan or to a debt management program. As long as you make on-time payments on your debts, debt consolidation and debt management won’t harm your credit the way debt settlement will. Additionally, debt settlement may not save you any more than these other options after you factor in its fees and tax liability.

Read more about debt settlement versus debt management.

If you compare debt settlement with bankruptcy, you’ll see that with Chapter 7 bankruptcy you can eliminate all of your debt, whereas debt settlement only settles a portion.

What Is the Difference between Debt Consolidation and Debt Settlement?

Debt consolidation combines multiple debt accounts into one, with one interest rate and one monthly payment. Instead of paying bills separately, you make a single payment to a financial institution or debt management company. The payment should have a lower interest rate and should be lower than the combined individual payments you were previously paying.

With debt settlement, your creditor agrees to accept less than what’s owed, but may not get the payment for a while as you put money into an escrow account until enough is accumulated to pay the agreed-to sum.

While you may pay a lower overall balance with debt settlement, debt consolidation doesn’t affect your credit score the way debt settlement will.

Credit Counseling as an Alternative to Debt Settlement

A reputable credit counseling provider can help you find a debt solution that fits your financial situation. These nonprofit consumer agencies offer free counseling, which includes a budget evaluation. They assess your total financial picture and make recommendations, guiding you toward a customized solution. Depending on your situation, the counselor may suggest a debt management program, which will have lower interest rates and fees on your accounts.

InCharge Debt Solution’s debt management program is a good alternative to debt settlement. With a debt management program, the credit counseling agency consolidates your payments, so you still make one monthly payment without borrowing more money. Additionally, you may qualify for waived fees and lower interest rates. You still must pay all you owe, but the fee to the nonprofit debt management program is between $30-$50 a month and your accounts are paid monthly and on time, so your credit score isn’t further damaged. These programs take 3-5 years.

Credit Card Debt Forgiveness Program: Reputable Nonprofit Debt Settlement

Nonprofit agencies are usually a better option for debt settlement than a for-profit companies. Nonprofit agencies are backed by the National Foundation for Credit Counseling and adhere to federal regulations that make sure they’re acting in the client’s best interests.

While traditionally nonprofit debt management programs don’t reduce balances, a new program, the Credit Card Debt Forgiveness program, allows consumers who qualify, to pay 50-60% of their debt balances. The new program has fixed payments, but the balance must be paid off in 36 months. There’s no interest charged on the payments. The program combines some of the best elements of nonprofit debt management with debt settlement, but without some of the hazards to the consumer debt settlement has, including:

  • The agreement with the creditor to waive 40%-50% of the amount owed is reached upfront, rather than negotiated, so the borrower immediately knows how much they will be paying.
  • Debt is paid off in fixed monthly payments over a 36-month period, rather than the lump sum amount that’s due in for-profit settlement when an agreement is reached.
  • No interest is charged on the balance owed, as opposed to for-profit, where interest charges and late payment penalties accrue until an agreement is reached.
  • Debt collectors can’t contact someone participating in a nonprofit debt settlement program.

InCharge Debt Solutions, as part of its counseling, can help you decide if Credit Card Debt Forgiveness is right for you. If it’s not, the counselor can help you explore other debt relief options.

Debt Settlement Pros & Cons

Commercials for debt settlement make a lot of bold claims, but from a trampled credit score to tax implications, find out the real price of debt settlement.

Learn More

Debt Management vs. Debt Settlement

Debt settlement and debt management are two approaches to reducing your debt. Both take years to achieve and both involve fees.

Learn More

Debt Consolidation

There are several types of debt consolidation, but in general, it combines your monthly bills into one consolidated payment – ideally at a lower interest rate.

Learn More

Sources

N.A. (ND) Coping with Debt. Retrieved from https://www.consumer.ftc.gov/articles/0150-coping-debt

N.A. (ND) Debt Collection FAQs. Retrieved from https://www.consumer.ftc.gov/articles/debt-collection-faqs

Regan, G. (2021, February 16) Options for Consumers in Crisis An Economic Analysis of the Debt Settlement Industry Fourth Edition. Retrieved from https://americanfaircreditcouncil.org/reports/options-for-consumers-in-crisis-an-economic-analysis-of-the-debt-settlement-industry-4/