Pros and Cons of Debt Settlement: What You Need to Know
A settlement could be the answer if you’re struggling to pay off a large debt.
September 26, 2022
This information is provided for informational purposes only, and is not intended to be construed as tax, legal, or accounting advice. You should consult your own tax, legal and accounting advisors before making financial decisions.
What happens if you have such a high debt load that you can’t reasonably pay it down?
While bankruptcy or credit counseling are popular options, debt settlement could also reduce debt load. However, you’ll need to assess your financial situation to determine if settling your debt is the best option.
In this guide, we’ll look at how debt settlement works, as well as the pros and cons of debt settlement.
What is debt settlement?
Also known as debt relief, debt settlement is a process where you negotiate with creditors to reduce your total debt. In exchange, you give the lender a lump sum payment, which is less than the original debt.
Some borrowers opt for debt settlement because it eliminates large amounts of debt for less than they owe. Creditors receive at least something in exchange — as opposed to the $0 they would receive if you don’t pay your debt — so creditors can benefit from debt settlement, too.
Remember debt settlement is only possible for unsecured debts, like credit cards and federal student loans. You can’t settle secured debt, like mortgages and cars. If you default on these types of debt, the creditor repossesses the property.
Lenders are under no obligation to accept your debt settlement offer, either. They have the power to ask for a larger lump sum or they might turn down the offer altogether.
How does debt settlement work?
If you want to pursue debt settlement, most consumers work with a debt relief agency. This agency specializes in debt settlement and acts as a go-between with consumers and lenders. A good debt settlement provider will negotiate with creditors to lower debt.
While they negotiate on your behalf, the debt relief company will likely advise you to stop making any payments on your debt. Instead, you will make payments into an escrow account. The debt relief company uses the funds in this account to make the lump sum payment and settle your debt.
In exchange for their services, debt settlement companies will charge a percentage of your enrolled debt, the total amount of debt you had when hiring them.
However, it’s possible to negotiate a debt settlement on your own, too. The downside is this option comes with added stress and a steep learning curve, which is why many consumers opt for debt settlement services.
You’ll likely need to spend a lot of time on the phone with your creditors, but you can ask for:
Reduced interest rates
If you have extenuating circumstances, like medical bills or job loss, this is the time to mention them.
What are my other options?
Debt settlement isn’t the only way to get out of debt. You could also pursue:
Making minimum monthly payments can take a long time and likely cost you more interest. But you can try to pay down debt by making at least the minimum monthly payment to prevent your debt from going to collections.
Credit counseling is typically a free or low-cost service from credit counseling agencies. Credit counselors create a debt management plan and help negotiate interest rates or fees, which can help reduce late payments' impact on your credit score.
Debt consolidation, or a debt consolidation loan, rolls debts into a single payment. Successful consolidation usually comes with a lower interest rate but doesn’t free borrowers from debt payments.
Declaring bankruptcy requires liquidating your assets. This means you’ll sell assets you own and use the funds to pay off your debts, including retirement savings and any property or vehicles you may have. Bankruptcy can help you get a fresh start, but it can be expensive because it often requires hiring a lawyer. It will also hurt your credit score.
Is debt settlement a good idea?
There are alternatives to debt settlement, but it can help you pay off the debt by reducing your total debt load. Weigh the pros and cons of debt settlement to decide if it’s a good option for you.
The pros of debt settlement
Debt settlement can help you get more financial breathing room. The process can take several months, but there are several reasons why borrowers opt for debt settlement:
Achieve debt relief
The most significant advantage of settling is paying off your debt. If you successfully negotiate with creditors, you could save money by reducing the total debt you owe.
Debt settlement saves borrowers $2.64 for every $1 paid in fees, according to a study by the American Fair Credit Council. Borrowers report an average of 30% savings on their original debt with debt settlement programs.
Avoid filing bankruptcy
Bankruptcy is always an option, but it can have a bigger impact on your credit score than debt settlement: Debt settlement stays on your credit report for seven years, while a Chapter 7 bankruptcy remains for ten years.
If you don’t want to liquidate property during bankruptcy, debt settlement could be a favorable alternative because you won’t have to sell assets of value.
Stop collection calls
Has your debt already gone to debt collectors? Once you agree with your creditors, you’ll stop receiving collection letters and phone calls.
Did you know creditors can sue you for unpaid debt? Settling your debt gives you the chance to reconcile with a creditor before they file a lawsuit.
The cons of debt settlement
While debt settlement can reduce your total debt load, it certainly isn’t without consequences. Consider the downsides:
A settlement isn’t guaranteed
Your creditors can refuse to accept a debt settlement offer. It’s often in their best interest to accept a reasonable offer, but they aren’t required to accept any settlement.
Some creditors refuse to work with debt settlement companies and will only work with consumers directly. Check your creditors’ policies in your loan paperwork or online account before you hire a debt settlement company.
Your debt may increase
If you work with a settlement company, they might tell you to stop making payments on your debt while they negotiate on your behalf. In the meantime, they will likely tell you to deposit money into an escrow account, which they will use to pay a lump sum to the creditor.
However, if the negotiations fall through, you will accrue interest, late fees and other penalties on your unpaid debt. This could leave you with more debt than you started with.
Settlement companies charge fees
If you hire a settlement provider to help you, you’ll pay a percentage fee to the agency. Every debt settlement provider is different, but they typically charge 20% to 25% of your total debt, which is pricey.
It will negatively affect your credit score
Debt settlement stays on your credit report for seven years. It won’t hurt your credit score as much as bankruptcy, but you will see a dip in your credit score. A lower credit score could mean you’ll be offered less favorable interest rates and loan terms.
You must pay a lump sum
You will need to pay a lump sum of hundreds or thousands of dollars to settle your debt. It’s difficult saving enough money for a lump sum payment, which means debt settlement might not be a realistic option for some borrowers, even if the total amount you have to pay is less than your original debt load.
Settlements affect your taxes
If you see a reduction in your debt of $600 or more, your creditor will report it to the IRS because the IRS considers debt forgiveness taxable income. If you negotiate a settlement, you may have to pay more in taxes this year.
Some settlement companies are scams
There’s always the potential for scams, so it’s critical to research reputable settlement providers before you share any personal or financial information.
It’s likely a scam if the company:
Requires upfront fees
Has a 100% settlement guarantee
Prohibits you from speaking to your creditor
If it sounds suspicious or too good to be true, it almost certainly is. Check a debt settlement company’s ratings on the Better Business Bureau to help make sure the company is legitimate.
Weigh the pros and cons of debt settlement
Debt settlement can eliminate your debt by offering a lump sum lower than your total debt load. It’s an attractive alternative to making minimum payments, using a nonprofit credit counseling service or declaring bankruptcy, but there are pros and cons to debt settlement.
The pros include:
Achieving debt relief
Stopping collection calls
The cons include:
No guarantees of a settlement
Fees to a settlement company
A decrease in your credit score
Paying a high lump sum
The risk of scams
It’s up to consumers to evaluate the pros and cons of debt settlement to determine if it’s the right option for overcoming a high debt load.
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