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Debt Settlement: How it works and the risks you face
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The Debt Settlement Process: What is 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 holds a bachelor's level degree in journalistic studies from Auburn University and a master's in education from Georgia State University. Prior to joining NerdWallet she was employed by 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 Jun 24, 2022 10:58 AM PDT
Editor: Kathy Hinson Lead Assigning Editor Personal financial, credit scoring, managing money and debt Kathy Hinson leads the Core Personal Finance team at NerdWallet. Previously, she spent 18 years with The Oregonian in Portland in capacities such as chief of the copy desk and team editor and designer. Prior experience includes news and copy editing for many Southern California newspapers, including the Los Angeles Times. She received a bachelor's degree in mass communication and journalism from The University of Iowa.
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Table of Contents
Table of Contents
The term "debt settlement" means that a creditor has accepted less than the amount you owe in full as a payment. When it has accepted that offer it is no longer able to harass you to collect the cash and you don't need to worry about the possibility of be sued for that specific debt.
It may sound like a good deal however, debt settlement could be risky.
Debt settlement can destroy your credit.
The process of settling a dispute can take a long time achieve -- typically between two and four years.
It isn't cheap.
If you're successful at debt settlement, it can take years before you realize that you owe tax on any forgiven debt. If you choose to use a debt settlement company that charges fees. This is the last option.
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How does debt settlement work
Debt settlement comes into play only if you've got a large number of late or skipped payments and even collections accounts. A creditor or collector will not accept less than you owe if there's evidence that suggests you may not have the amount the amount you initially agreed to.
Your will have been shredded and you'll feel hopelessly behind and your income will not be enough to pay the debts you owe.
Debt settlement companies work with creditors to cut down the amount of debt you have to pay, mainly on debt that is not secured like credit cards. It's not an option for some kinds of debts for example, a home that is foreclosed or a car that may be repossessed. The majority of companies do not pay federal student loans, but you might be eligible to . If you're having trouble paying your student loans, an might help you.
Settlement offers only work if it seems you won't pay at all, so you stop making payments to your debts. Instead, you establish a savings account and put the monthly installment there. If the settlement company is convinced that the account has enough to warrant a lump-sum payment and talks on your behalf to the lender to accept an amount that is less.
Readers can also ask questions.
Do debt consolidation loans hurt your credit?
The debt consolidation process can improve your credit score if you pay on time or shrinks balances on accounts that are revolving in particular if credit card balances were exceeding their limits. Credit is affected if you run up credit card balances again, close most or all of your other cards or make a late payment on the credit consolidation loan.
What can I do to reduce my credit card delinquence?
Bankruptcy and debt settlement can reduce or completely eliminate debt from credit cards, however they can severely affect your credit score. Debt management reduces interest ratesand the effect on your credit is less severe. It can also reduce interest rates as well.
How can I lower my credit card?
Reduce your debt by three steps. Get a handle on what you owe. 2. Assess which payoff strategy will best suit your needs. 3. Set a goal and keep track of your progress.
Debt settlement risks
Some companies offering debt settlement say they can reduce the amount of debt you owe by 50 percent and get your debt free in only 36 months.
But, the process isn't as simple or as straightforward as it appears. We believe that debt settlement should be a only option in the end.
Here are the potential risks involved with the settlement of debt:
Your credit rating will take a hit If you're still not in debt on your accounts and you're not, you'll be after you redirect debt payments towards an account for settlement. Debts that are owed and owing off by lenders remain on your for seven years.
Penalties and interest continue to accumulate: You'll most likely be hit with late charges and penalty fees as well. Interest will continue to accrue on your balance.
There's no assurance of success: The two largest companies for debt settlement are and . Freedom Debt, for instance claims to have paid greater than 10 billion dollars in debt for more than 650,000 customers since 2002. However, there's no guarantee that the debt settlement company will be able to settle your debt for significantly less, considering certain creditors don't negotiate with them.
According to a study by the Center for Responsible Lending, which is a non-profit research and policy institute the majority of consumers will need to settle at least four accounts before receiving a net gain. Additionally, the amount of debt can increase as fees accumulate and aggressive attempts to collect might continue throughout the negotiation process.
You must pay the cost when a debt settles: By law, these companies can't charge you upfront fees. They typically have a percentage charge for each amount they pay, depending on that debt's balance when you enrolled into the program. Some charge a percentage of the debt eliminated by the settlement.
For example, say you owe $10,000, and an agency agrees to negotiate a deal for $6,000. The agency is charged 25%.
If the agency charges a percentage of debt that is settled that is, you'd pay the debtor the amount of $6,000 and pay an agency $2500 in charges (25% of the $10,000 balance enrolled). Total: $8,500.
If the agency has a percentage charge for eliminating debt, you'll pay the creditor $6,000 and the agency $1000 in fees (25% of the $4,000 of eliminated debt). Total: $7,000.
You'll pay additional fees: Besides the fees due the debtor when the debt is settled clients may be charged additional fees, such as an initial setup fee and a monthly fee to keep the account set up under the program.
The debt that you forgive could be tax-deductible Also, you should consider that Internal Revenue Service generally regards forgiven debt as income. You may want to consult an accountant about any additional tax obligations you'll be taking when you settle your debt.
If you decide to engage the services of a debt settlement professional Be careful. It's easy to let your guard down when you're in a state of desperation and are able to see the promises of . A study by the National Consumer Law Center has stated that debt settlement firms are "almost never worthwhile and can get consumers into even more financial difficulties."
The Consumer Financial Protection Bureau takes a somewhat softer view, but still cautions consumers strongly, saying that dealing with these firms is risky and that other alternatives should be considered first. Over 300 complaints about debt settlement companies to the CFPB from 2014. The most frequent complaints included fraud and fees that were too high.
Alternatives to debt settlement
Michael Bovee, a debt settlement coach, and often a 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.
For borrowers who are overwhelmed by debt that is not secured, like credit cards, think about how your options compare with . It is usually the better choice. Yes, bankruptcy will ruin your credit for years however, the process of rebuilding is able to begin right away. Consultations with a bankruptcy lawyer are generally free, however you'll have to pay filing and legal fees if you decide to go this option.
"If you are able to erase your debts in the form of a Chapter 7 bankruptcy, that's the best option over trying to settle settlements," says NerdWallet columnist Liz Weston, author of "Your Credit Score" and "Deal with Your Debt." "Only if Chapter 7 isn't an option -- you refuse to declare bankruptcy, or if you only be eligible for an Chapter 13 repayment plan -- should you consider the possibility of settling your debt."
If you aren't eligible for a bankruptcy or don't intend to make one happen, consider a offered through a nonprofit . The option you choose to take won't generally reduce the amount that you'll have to repay, but it may reduce your monthly payments by spreading them out or by reducing your interest rate. It's less likely to have an impact on your credit than bankruptcy or an agreement to settle debts.
If you decide to pursue settlement, you can do so.
If you feel that debt settlement is the most effective or most appropriate choice for you, and you'd like assistance with the debt resolution option, Bovee has tips for selecting a company with care:
Check with the to see the history of complaints.
Avoid any business which offers cash in advance or promises that the debt will be paid.
Make sure fees are structured in a proportion of debt eliminated rather than of the debt balance at enrollment. This provides the business with a reason to trim more of your debt.
Do not trust companies that claim that they will help you contest debts to have them declared "invalid" (a tactic that could backfire, resulting in more aggressive enforcement towards you).
If you're not planning to use a debt-settlement company think about hiring a lawyer or making it your own.
A lawyer can charge by the hour, have one flat fee per creditor or take a percentage of the debt or debt that is eliminated.
Once you're significantly behind you are, it's not a bad idea to reach out to your creditors. Some banks have hardship programs that may be able to assist. However, make sure you are able to afford any reduced payment options your bank might provide.
If you're considering trying learn about the likely outcomes.
It is possible to collect the most cash you can in order to make a lump sum offer, whether this means working part-time, selling sports equipment that's been languishing in the basement or taking money out of your cousin. (Creditors might be more likely to accept a lump-sum deal as it allows them to pay immediately, rather than making a bet on payments that might not come.) Be aware that some creditors might have a policy against settlement of dues.
Author bio Bev O'Shea was a credit reporter at NerdWallet. Her work has been featured in the New York Times, Washington Post, MarketWatch and elsewhere.
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