The Pros and Cons of Debt Settlements
What is debt settlement? Sometimes called “debt arbitration” or “debt negotiation,” 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.
Choose Your Debt Amount
Maybe you’ve seen the signs on the side of the road, or you’ve received solicitor calls or brochures that promise to “Eliminate debt now!” The offers are tempting. Unfortunately, in some cases, they’re simply not legitimate. Not only may these claims be dishonest, some are simply scams designed to take advantage of desperate people.
The term debt settlement comes from the idea that the creditor agrees to “settle” your account, and generally includes the closing of the account.
Is debt settlement ever a legitimate and viable option? Yes, but only under certain conditions, and it can cause potentially negative effects to your financial situation and credit score (see the potential risks and pitfalls that follow.)
Policies on account settlement vary, and it is always the right of creditors to dictate their own terms, or even refuse to consider settling for less than what is owed. Determining factors may include the total amount of debt owed, the length of time an account has been active, the length of time the account has been delinquent, along with other criteria.
Benefits of Debt Settlement
If a creditor being willing to accept a percentage of what you owe and cancelling the rest of the debt sounds too good to be true, it often is exactly that. Outside the debt settlement industry, debt settlement is viewed as risky business for consumers in part because it can be a playground for scam artists. In some cases, that life preserver tossed your way won’t keep your head above water.
But consumers reasonably considering debt settlement also recognize they have limited options. And the benefits for those people are worth consideration.
1. Get Relief from Unbearable Debt and Repay Your Debt Faster
Expediency isn’t always at the top of the list of benefits to other financial relief avenues, such as debt management plans and credit counseling programs. Debt settlement can help people with overwhelming debt pay less on the amount owed and, often, the process of settling debt is faster than other routes.
How fast? A legitimate debt settlement program could allow you to pay off your debt in two to four years. Other options — debt consolidation, bankruptcy, credit counseling repayment programs — typically take longer.
2. Avoid Bankruptcy
Most often consumers in need of debt settlement aren’t deciding between that route and repaying their entire debt over a longer period of time. The conventional way hasn’t worked for them. The choice frequently comes down to debt settlement versus bankruptcy,
One thing to keep in mind is that debt settlement, with whatever strings attached, has a negative impact your finances, though not as much as Chapter 7 or Chapter 13 filings. So, it can be a more palatable alternative to filing bankruptcy.
What’s the benefit of debt settlement to creditors? They might not spell it out, but debt settlement for creditors means they at least get some money. It is often an acknowledgment that they could receive even less money if someone files Chapter 13 bankruptcy and possibly nothing at all through Chapter 7 bankruptcy.
For you, it’s no small difference between debt settlement and bankruptcy. While debt settlement will stay on your credit report for seven years, bankruptcy filings can be a life-long companion.
A bankruptcy filing remains on your credit report for seven years (Chapter 13) or 10 years (Chapter 7) and it can follow you even longer since credit cards, loans and even some job applications ask if you’ve ever filed bankruptcy.
3. Your Debt Won’t Be Sent to Collections or Charged Off
Debt settlement can help people avoid their debt being sent to collections or being “charged off,” which means it has been sold to a debt collection agency.
Debt settlement won’t miraculously end your financial problems, in the short term or long term. But one clear benefit is that it will stop calls from debt collectors once an agreement is reached.
Lowering your debt amount and helping you avoid bankruptcy are monetary benefits, albeit benefits with inherent risks. Stopping calls from creditors and collection agencies is a less tangible but equally important benefit for some consumers feeling overwhelmed and harassed.
4. Avoid Being Sued for Your Debt
Depending on your circumstances, you may have a different opinion on what constitutes a worst-case scenario. Facing a lawsuit is certainly near the top of everybody’s list.
Debt settlement might help you avoid being sued for credit card debt and being involved in a long contentious proceeding.
Unsecured debt — credit cards, store cards or unsecured loans – can be settled. Secured debt — mortgages and car loans – can’t be settled. The home will be foreclosed or the car will be repossessed.
Even with unsecured debt, creditors do not have to agree to settle debt. Or they can offer a settlement that you might not be able to afford.
But since lawyers don’t come cheap for anyone, credit card companies often have clear incentive to settle a debt and avoid legal proceedings.
Disadvantages of Debt Settlement
The advantages of debt settlement — in potential dollars saved — might make it a compelling option for debt relief but consumers should consider the strings attached in making the best decisions to get out of debt.
1. Debt Settlement Fees
Many debt settlement providers charge high fees, sometimes $500-$3,000, or more. But these fees are not applied to your debt – they go straight into the agencies’ pockets.
2. Debt Settlement Impact on Credit Score
While not as devastating as a bankruptcy, debt settlement will have a negative impact on your credit score if you work directly with your creditors, as the settlement may be reported by the creditor to each of the three leading credit bureaus. This will in turn affect your future loan terms, credit availability, employment opportunities, and more. Consider those consequences if you plan on getting a mortgage soon after debt settlement.
» Learn More: How Debt Settlement Impacts Credit Score
3. Holding Funds
Here’s one debt settlement scenario some consumers have reported experiencing: A provider requires you pay a large lump sum, earmarked for debt repayment, which it holds in escrow for months or even years. The provider tells you it needs the time to “negotiate” with your creditors, while little progress is made on your case. It simply holds your cash, which you could be using for better things. Worse, providers may refuse to return the money, if you’ve signed anything giving them rights to it (even if you didn’t realize you had).
4. Debt Settlement Tax Implications
If a creditor agrees to settle your debt in exchange for a reduced payment, you may still be responsible for taxes on the reduced debt. Basically, if the settlement results in a debt reduction of $600 or more, the creditor is required to notify the IRS. For example, if you owe a creditor $10,000 and it agrees to settle with you for a one-time payment of $7,500, the reduced amount, $2,500 must be included as part of your taxable income.
5. Creditors Could Refuse to Negotiate Your Debt
That debt settlement company you’re paying to negotiate a lesser amount may not be able to reach an agreement. Debt settlement is at the discretion of each individual creditor. Some creditors outright refuse to deal with debt settlement companies.
6. You May End Up with More Debt Than You Started
Debt settlement companies recommend you stop payment on your debts while they negotiate with creditors. That negotiation is often not a streamlined process and can take quite some time.
Stopping payment on a debt means you could face late fees and accruing interest. Additionally, just because a creditor agrees to lower the amount you owe doesn’t mean you’re free and clear on that particular debt. Forgiven debt could be considered taxable income on your federal taxes.
Do-It-Yourself Debt Settlement
A commonly unknown but important fact is this: You can negotiate a debt settlement by yourself in the same way a debt settlement provider can. While they may claim to know legal secrets, or have special relationships or concessions with creditors, they don’t. There are no magic tricks, loopholes or other methods they can legally provide.
But they still get plenty of customers. And when debt settlement agencies contact and negotiate with creditors on behalf of consumers, essentially becoming the “middle man,” is when people are at risk. The problem has become so prevalent that state officials have begun stepping in to protect consumers.
Debt Settlement Alternatives
Depending on your situation, you may have some leverage you can use to negotiate your own debt relief plan. Call your creditors directly and ask them if they will lower your interest rates and/or waive late or over-limit fees to reduce your balances. Creditors are becoming more and more willing to work with customers. Hubert H. Rivera, Vice President of Consumer Outreach at InCharge Education Foundation, a nonprofit organization providing financial education and credit counseling nationwide, agrees that “Creditors understand that plenty of us have been through rough economic times and are willing to extend a helping hand – and many times, this help is just a phone call away.
We’ve included some debt relief strategies that you can begin on your own – and they don’t cost a dime – such as:
A reputable credit counseling service, like InCharge Debt Solutions, can help you find a solution that fits your personal financial situation. These nonprofit agencies offer free credit counseling sessions, which include a budget evaluation, online, via phone or face-to-face. They assess your total financial picture to make recommendations accordingly, and guide you towards a customized solution. A credit counseling service could help you pay off your debt through debt management, a bill consolidation program with lower monthly payments, reduced interest and a 3-5 year commitment.
Credit counseling is a viable option for thousands of consumers that can help avoid bankruptcies, wage garnering and court judgments. In fact, leading creditors have recently banded together to begin offering hardship plans that allow consumers to pay more affordable percentages of their total balances, which also includes lowering interest rates, so debts can be repaid within 3-5 years.
Alternative options, such as referrals to social service organizations, or legal assistance, may also be offered.
Credit Card Balance Transfer
One option if you have credit card debt is to transfer the balance to another card.
This strategy is usually employed to take advantage of an introductory 0% interest offers on a new card.
Is it that simple? Not always.
First, you must qualify for a credit card balance transfer, which usually means a credit score of 670 or better. Second, you need to determine whether you’ll pay more on the interest payments of your existing card than the fees you’d be charged to transfer a balance. Ideally, you’d try to pay the balance off on the new card before the promotional period expires to avoid interest.
Nonprofit Debt Settlement
The avenues for consumers to seek debt relief through for-profit debt settlement companies are well known by now and — as we’ve outlined — not without sizeable potholes.
Nonprofit debt settlement — like InCharge Debt Solution’s “Credit Card Debt Forgiveness Program” — is an alternative worth examining.
Some conditions must be met for eligibility in the forgiveness program:
- You must carry a minimum balance of $1,000 and have not paid on it for 120 days.
- Your creditor must have agreed to participate in the program, and you must agree to pay off the debt amount within 36 months.
Those are relatively minor hurdles to overcome. The benefits of the Credit Card Debt Forgiveness Program should help you avoid some of the pitfalls of debt settlement.
For example, the biggest pitfall of debt settlement is that the lender is under no obligation to accept an offer to settle the debt.
In standard debt settlement, consumers are asked to stop making payments to creditors and instead, spend 2-3 years putting money in an escrow account to make a lump-sum offer to the lender. During that 2-3 year time frame, late fees and interest fees are added to the debt, making the goal more difficult to reach.
And even when you reach what you think is a suitable settlement amount, the lender can say “No!” and refuse the offer.
That’s not the case with Credit Card Debt Forgiveness.
Creditors agree up front to accept 50%-60% of the balance owed and sign an agreement saying so. The consumer’s payments are spread evenly over 36 months, with the balance reduced each month until it is paid off. If you wish to pay the sum off early, you can do so without penalty.
A side benefit of enrolling in the forgiveness program: Collection agencies and law offices stop harassing you, while trying to recoup the debt. That includes halting lawsuits filed to collect the debt.
But the biggest benefit is the support of a trusted credit counselor from a nonprofit agency and the assurance that you’ll know the terms of the Credit Card Debt Forgiveness Program before your debt problems spiral out of control.
About The Author
After a 45-year career in journalism, Robert's focus is helping consumers cope with personal finance issues. Finding solutions to paying off credit card debt, mortgage payments and that darn student loan, is far more fulfilling than explaining why the Cleveland Browns can't win (It's the quarterback!!). Robert wrote about the Browns and all Cleveland sports as a columnist at the Plain Dealer before transitioning to television sports commentary at WKYC. Now, his passion is helping people navigate their personal finances.