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Credit Settlement: How It works and the risks you face
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Debt Settlement: How It Works and Risks You Face
By Bev O'Shea personal finance writer | MSN Money, Credit.com, Atlanta Journal-Constitution, Orlando Sentinel Bev O'Shea is a former NerdWallet authority on consumer credit, scams and identity theft. She has a bachelor's degree in journalistic studies from Auburn University and a master's in education from Georgia State University. Before coming to NerdWallet she worked for newspaper publishers, including daily ones, MSN Money and Credit.com. Her work has been featured on The New York Times, The Washington Post, the Los Angeles Times, MarketWatch, USA Today, MSN Money and elsewhere. Twitter: @BeverlyOShea.
Updated on Jun 24, 2022 at 10:58AM PDT
Edited by Kathy Hinson Lead Assigning Editor Personal financial, credit scoring, managing money and debt Kathy Hinson leads the Core Personal Finance team at NerdWallet. Prior to joining NerdWallet, she worked for 18 years at The Oregonian in Portland in capacities such as chief of the copy desk and team leader for design and editing. Prior experience includes news and copy editing at several Southern California newspapers, including the Los Angeles Times. She graduated with a bachelor's in journalism and mass communications in The University of Iowa.
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Table of Contents
Table of Contents
The term "debt settlement" means that a creditor has agreed to accept less than what you owe in full as a payment. Once it accepts that deal it is no longer able to hound you for the amount and you won't have to be concerned about whether you'll get sued over that particular debt.
It seems like a great deal, but debt settlement can be risky.
Debt settlement can destroy your credit.
The process of settling a dispute can take a long time complete -- usually between two to four years.
It could be expensive.
Even if you succeed at debt settlement it may take years to complete and you could realize that you owe tax for any debt that you have forgiven. If you choose to use a debt settlement company, you'll pay fees. It is a last resort.
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How does debt settlement work
Debt settlement can be used only if you have a lot of payment due dates or missed payments and even collections accounts. A creditor or collector will not accept lesser than what you owe when there's a an indication that you might not be able to pay the amount that you originally agreed to.
Your will have been shredded and you'll feel hopelessly behind and your income isn't enough to keep up with the debts you owe.
Companies that deal with creditors to lower what you owe, mostly on unsecured debt such as credit cards. It's not an option for some types of debts, such as a house that is foreclosed or a car that may be taken back. The majority of companies do not pay federal student loans however you might be in a position to . If you're struggling with your student loans, an might help you.
Settlement offers work only when you don't make any payments, and you don't make payments to your loans. Instead, you open an account for savings and make the monthly installment there. When the company that settles your account believes the account has enough for a lump-sum offer, it will negotiate on your behalf with the creditor to agree to the lesser amount.
Readers also ask
Do debt consolidation loans hurt your credit?
The debt consolidation process can improve your credit if it helps to make timely payments or decreases account balances, especially if the balances on your credit cards were close to their limits. Your credit if you run up credit card balances again and close all or the majority of your other cards or make a late payment on the credit consolidation loan.
How can I cut down my credit card credit card
Bankruptcy and debt settlement can help to reduce or completely eliminate debt from credit cards, however they can severely affect your credit score. The management of debt reduces interest ratesand the impact on credit is less significant. This can lower interest rates as well.
How can I lower my credit card?
Reduce your debt in three steps: 1. Determine the amount you owe. 2. Determine which payoff strategy is going to best suit your needs. 3. Set a goal and keep track of your performance.
The risk of debt settlement
Some companies offering debt settlement say they can reduce credit by up to 50% and make your debt free in only 36 months.
However, the procedure is not as clear-cut or as easy as it sounds. In our opinion, debt settlement should be the last resort.
Here are the potential risks involved with the settlement of debt:
Your credit rating will suffer a blow If you're still not delinquent on your accounts, you will be once you transfer debt payments to the settlement account. The debts and accounts that are delinquent and charged off by lenders stay on your credit for seven years.
Penalties and interest will continue to accrue: You'll likely be hit with late fees and penalty fees as well. Interest will continue to accrue on your balance.
There's no assurance of success: The two largest debt settlement firms are and . Freedom Debt, for instance claims to have settled greater than 10 billion dollars worth of debt for more than 650,000 customers since the year 2002. There's no assurance that the debt settlement firm can resolve your debt for much less, given that some creditors are not negotiating with them.
According to a study by the Center for Responsible Lending, an independent research and policy institute, most consumers would have to settle at minimum four accounts before receiving the net gain. In addition, debt totals could increase as fees are accrued and aggressive attempts to collect may continue during the negotiation process.
You have to pay an amount in the event of a debt being settled by law. companies can't charge you up front fees. Most of them have a percentage charge for each amount they pay, depending on the debt's balance when you enrolled in the program. Some charge a portion of the debt eliminated by the settlement.
As an example, suppose you owe $10,000 and the agency negotiates a deal for $6,000. The agency will charge 25%.
If the agency is charged a percentage of the debt that is settled then you'll pay the creditor $6,000 and pay an agency $2500 in charges (25% of the $10,000 balance that you enrolled). Total: $8,500.
If the agency is charged a percentage of the eliminated debt, you'll pay the lender $6,000 and the agency $1,000 in charges (25 percent of the $4,000 of eliminated debt). Total: $7,000.
You'll pay additional fees in addition to the charges paid to the debtor when the debt is settled the customer may also be subject to other fees, such as an initial setup fee and a monthly fee to keep the account created under the program.
If you have forgiven your debt, it could be tax deductible It is important to know that Internal Revenue Service generally regards forgiven debt as income. You may want to consult a tax professional about other taxes you'll be liable upon settling your debt.
If you do decide to engage the services of a debt settlement professional, be careful. It's easy to fall into a state of panic when you're feeling desperate and are able to see the promises from . It's been reported that the National Consumer Law Center has said debt settlement companies are "almost never worth it and could lead consumers into deeper financial trouble."
The Consumer Financial Protection Bureau takes more of a softer approach, but still cautions consumers strongly in advising that dealing with such companies can be risky and that alternative alternatives should be considered first. There have been over 300 complaints about debt settlement companies to the CFPB since 2014. Most of the complaints included fraud and fees that were too high.
Other options to settle debt
Michael Bovee, a debt settlement coach and a frequent critic of his industry (he has testified before the Federal Trade Commission in favor of more regulation), advises erasing your debt through Chapter 7 bankruptcy and starting from scratch, if you've got the choice.
If you are a borrower who is overwhelmed with debts that are not secured such as credit cards, think about how your options compare, like . A is almost always the better choice. Yes, bankruptcy will ruin your credit for many years, but the rebuilding process can begin immediately. Consultations with a bankruptcy lawyer are typically free, though you'll have to pay filing and legal costs if you opt for this option.
"If you are able to erase your debts through bankruptcy, such as a Chapter 7 bankruptcy, that's an excellent alternative to trying to negotiate settlements," says NerdWallet columnist Liz Weston, author of "Your Credit Score" and "Deal with Your Debt." "Only if Chapter 7 isn't an option and you decide not to apply for bankruptcy, or you can only qualify for a Chapter 13 repayment plan -- should you consider the option of debt settlement."
If you don't qualify for a bankruptcy or don't wish to declare one, you might consider the possibility of a donation through a nonprofit . The option you choose to take won't necessarily reduce the amount you must repay but it can decrease your monthly payment by stretching them out or through reducing your interest rate. It's less likely to have an impact on your credit than bankruptcy or a debt settlement.
If you decide to pursue settlement, you can do so.
If you think debt settlement is the best or most appropriate choice for you and you want some help in the process of pursuing your debt, Bovee has tips for selecting a company with care:
Contact the company to determine whether there's a history of complaints.
Beware of any business which offers cash in advance or promises that your debt will be paid.
Make sure fees are structured in a proportion of debt eliminated rather than of debt balance at enrollment; that gives the company incentive to reduce your debt.
Beware of companies who promise to assist you in resolving debts to have them declared "invalid" (a strategy that can backfire and result in more aggressive enforcement against you).
If you're not planning to use a debt-settlement company, consider using an attorney or do it yourself.
Lawyers can bill by the hour, have a flat fee per creditor or take a percentage of the debt or debts that are eliminated.
If you're in serious debt, it usually doesn't hurt to contact your creditors. Some banks have hardship programs which could be able to help. However, make sure you are able to afford any reduced payment options your bank might provide.
If you're interested in trying to do it, learn the likely outcomes.
You might want to gather as much cash as you are able to to make a lump-sum offer, whether this means taking a part-time job or selling equipment for sale which has been sat in the basement or taking money out of your cousin. (Creditors might be more likely to accept a lump sum offer that allows them to receive money quickly, instead of taking a chance on payments that might not come.) Also be aware that some creditors may have a policy against paying off debts.
The author's bio: Bev O'Shea is a former credit writer at NerdWallet. Her work has appeared in the New York Times, Washington Post, MarketWatch and elsewhere.
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