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The Debt Settlement Process: What is It works and the risks you face
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Debt Settlement: How It Does It and the Risks You Take
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 journalism from Auburn University and a master's in education from Georgia State University. Prior to joining NerdWallet, she worked for the daily papers, MSN Money and Credit.com. Her work has been featured in The New York Times, The Washington Post, the Los Angeles Times, MarketWatch, USA Today, MSN Money and other publications. Twitter: @BeverlyOShea.
Updated on Jun 24, 2022 at 10:58 AM PDT
Written by Kathy Hinson Lead Assigning Editor Personal financial, credit scoring, financial management and debt Kathy Hinson leads the Core Personal Finance team at NerdWallet. In the past, she worked for 18 years at The Oregonian in Portland in capacities such as chief of the copy desk and team editor and designer. Her previous experience included news and copy editing at many Southern California newspapers, including the Los Angeles Times. She earned a bachelor's degree in mass communications and journalism at Iowa's University of Iowa.
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Table of Contents
Table of Contents
A creditor has accepted less than the amount you have to pay as full payment. Once it accepts that deal, the creditor can't continue to hound you for the cash and you don't need to worry about the possibility of get sued over that particular amount of debt.
It may sound like a good deal however, debt settlement could be risky:
Debt settlement can destroy your credit.
A settlement may take a long time to accomplish -- often between two to four years.
It isn't cheap.
Even if you are successful in settling your debt it could take years to complete and you could discover you owe tax on any forgiven debt. And , if you work with a debt settlement company and pay for fees, you'll have to pay. This is not a last resort.
Make sure you track your debt the simple way
Join NerdWallet to view your current financial breakdown and future payments all in one place.
How do you deal with debt
Debt settlement comes into play only when you have many payment due dates or missed payments and perhaps collections accounts. A creditor or collector will not agree to pay less than you owe when there's a an indication that you might not be able to pay the amount that you originally agreed to.
Your confidence has been destroyed, you will feel overwhelmed and bewildered, and your income isn't enough to keep up with your debt obligations.
The companies that offer debt settlement deal with creditors to lower what you owe, mostly on unsecured debt such as credit cards. This isn't an option for certain types of debts, such as a house that is foreclosed or a vehicle that could be repossessed. Companies typically don't settle federal student loans however you might be in a position to . If you're having trouble paying your student loans and need help, this may be a good option for you.
Settlement offers work only when you don't pay at all, so you stop making payments on your loans. Instead, you open a savings account and put the monthly installment into it. Once the settlement company believes the savings account is sufficient to make a lump sum offer, it will negotiate on your behalf with the creditor to agree to an amount that is less.
Readers can also ask questions.
Do debt consolidation loans hurt your credit?
Debt consolidation may help your credit score if you pay on time or decreases account balances in particular if credit card balances were exceeding their limit. Credit is affected if you run up credit card balances again and close all or the majority of your cards or fail to pay your debt consolidation loan.
How do I reduce my credit card debt?
Debt settlement and bankruptcy can help to reduce or eliminate credit card debt, however they can severely affect your credit. Debt management reduces the rate of interest, and its impact on your credit is less significant. It can also reduce interest rates as well.
How can I lower my debt?
Reduce your debt in three steps: 1. Find out what you owe. 2. Assess which payoff strategy will be most effective for your situation. 3. Set a goal and track your progress.
The risk of debt settlement
Some debt settlement companies say they can cut your debt by 50%, and get your debt free in only 36 months.
But, the process isn't as simple or as straightforward as it appears. In our opinion, debt settlement should be a only option in the end.
Here are the risks that come with the settlement of debt:
Your credit score will suffer a blow: If you're not already in debt then you will be when you transfer debt payments to an account for settlement. Delinquent accounts and debt charged off by lenders will remain on your credit for a period of seven years.
Interest and penalties continue to accrue: You'll probably be hit with late charges as well as penalty fees. Interest will continue to accrue on your balance.
There's no guarantee of success The two biggest debt settlement firms are . Freedom Debt, for instance, says it has settled more than $10 billion of debts for more than 650,000 customers since the year 2002. But there's no guarantee that the debt settlement company can resolve your debt for significantly less, considering certain creditors don't negotiate with them.
According to a report by the Center for Responsible Lending, which is a non-profit research and policy organization, most consumers would have to settle at minimum four accounts before receiving a net benefit. Additionally, the amount of debt could increase as fees are accrued and aggressive attempts to collect may continue during negotiations.
You have to pay the cost in the event of a debt being settled by law. These firms aren't able to charge up front fees. Most of them have a percentage charge for every debt they settle, based 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 your agency negotiates with you a settlement for $6,000. The agency is charged 25%.
If the agency is charged a percentage of the paid debt, you'd pay the creditor $6,000 while paying an agency $2500 in fees (25% of the $10,000 amount enrolled). Total: $8,500.
If the agency has a percentage charge for eliminating debt, you'd pay the creditor $6,000 , and the agency $1,000 in charges (25 percent of the $4,000 in eliminated debt). Total: $7,000.
You'll pay additional fees In addition to the fees that are due the debtor when the debt is settled the customer may also be subject to other costs, including the setup fee and the monthly cost to maintain the dedicated account that is set up in the program.
If you have forgiven your debt, it could be tax deductible Also, you should know that Internal Revenue Service generally regards forgiven debt as income. You might want to talk to an expert in taxation regarding any other taxes you'll be liable when you settle your debt.
If you decide to hire the debt settlement expert, be careful. It's easy to let your guard down when you're desperate and see promises from . A study by the National Consumer Law Center has declared that debt settlement companies are "almost never worth it and could lead consumers into deeper financial troubles."
The Consumer Financial Protection Bureau takes an empathetic view but still cautions consumers strongly, saying that dealing with such companies is risky , and other options should be explored before. There have been over 350 complaints filed against companies that deal in debt to the CFPB from 2014. The most frequent complaints included fraud and fees that were too high.
Other options to settle debt
Michael Bovee, a debt settlement coach who is often a critic of his field (he has presented evidence to the Federal Trade Commission in favor of more regulation) He advises you to erase your debts with Chapter 7 bankruptcy and starting over, if you're given the choice.
For those who are burdened with debts that are not secured such as credit cards, think about how your options compare to . It is usually a better option. A bankruptcy can affect your credit score for many years, but the rebuilding process 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 choose this route.
"If you are able to erase your debts in the form of a Chapter 7 bankruptcy, that's an excellent alternative to trying to settle the settlement," says NerdWallet columnist Liz Weston, author of "Your Credit Score" and "Deal With Your Debt." "Only in the event that Chapter 7 isn't an option (you decide to not file for bankruptcy, or you only qualify for an Chapter 13 repayment plan -or if you're considering the option of debt settlement."
If you're not eligible to file a bankruptcy, or don't intend to file one, think about the possibility of a donation through a nonprofit . Going that route will not necessarily reduce the amount you have to pay, but it may lower your monthly payments by spreading them out or through reducing your interest rate. It will have less impact on your credit score than either bankruptcy or an agreement to settle debts.
If you choose to go for settlement
If you think it is the right option for you and would like some help in the process of pursuing your debt, Bovee has tips for choosing a company wisely:
Find out if there's a complaint history.
Stay away from any company who offers money in advance or promises your debt will be paid.
Be sure that fees are arranged as a percentage of debt canceled instead of the balance of your debt at enrollment; that will give the company a reason to trim more of your debt.
Avoid companies that promise to assist you in resolving debts in order to declare them "invalid" (a method that can backfire and result in more aggressive action at your expense).
If you're not sure whether you want to use a debt-settlement company, consider using a lawyer or do it yourself.
A lawyer can charge by the hour, have one flat fee per creditor or charge a percentage of debt or debt that is eliminated.
If you're in serious debt you are, it's not a bad idea to reach out to your creditors. Certain banks offer hardship programs that could help. However, make sure you are able to afford any reduced payment options your bank may offer.
If you want to try , educate yourself on what's likely to happen.
It is possible to collect the most cash you are able to to make a lump-sum offer, whether that's doing a part-time job selling the sports equipment which has been sat in the basement, or borrowing money from your friend. (Creditors might be more likely to accept a lump-sum deal, which gives them money immediate, rather than making a bet on payments that might not come.) Be aware that some creditors might have a policy against settlement of dues.
About the author: Bev O'Shea is a former credit writer at NerdWallet. Her work has been featured on the New York Times, Washington Post, MarketWatch and elsewhere.
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