How Debt Settlement Works
Casey is a reformed sports journalist tackling a new game of financial services writing. Mike Francesa once called her a “great girl.”
At a Glance
Debt settlement is when a creditor agrees to accept less than the full amount of debt that you owe, usually in exchange for a lump sum. A debt settlement can limit you from getting bothered by debt collectors and prevent a lawsuit. But settling your debt comes with risks, too.
How does debt settlement work?
Debt settlement typically is done by a third-party debt settlement company. Typically, the debt relief company will contact your creditors for you to negotiate a settlement. Debt relief service will cost you a fee, but you won’t owe the organization anything until after they’ve settled your debt.
Investigate any debt relief service before getting involved with them and be sure to get everything in writing. Check them out with your state’s Attorney General1 and local consumer protection agency to see if there are any complaints against them on file.
Debt services organizations must give you the following information before you sign up:
- Price and terms: The company has to disclose any fees and conditions involved in its services
- Results: The company has to tell you how long it will take for it to make an offer to each creditor for a settlement
- Offers: The organization has to reveal how much money you have to save before it will make an offer to creditors on behalf of you
- Non-payment: If the organization requests that you stop making payments on your credit card bills, this is a red flag. The company must tell you about any possible negative consequences you may face if you stop making payments.
A debt settlement company may require you to make regular deposits into a special, escrow-like savings account designed to go toward your lump-sum payment. These organizations also might encourage you to stop making monthly payments to other creditors while they negotiate for you. This can be detrimental to your credit score.
If and when the debt settlement company reaches an agreement with your creditor, you’ll need to agree to the settled amount. That’s when the debt relief company can start charging you for their service. But bear in mind, there’s no guarantee that a debt relief company will be able to reach a debt settlement agreement for all your debt.
Debt settlement pros and cons
While there are a handful of benefits of debt settlement, be aware that there are plenty of risks involved as well.
Benefits of debt settlement
Using a debt settlement company to settle your debt could:
- Lower the amount of debt you have
- Prevent you from having to file bankruptcy
- Get rid of debt collectors and creditors
- Could improve credit score in the long term: While your credit score will take a hit in the immediate, your score should improve over time because you’ll lower your outstanding debt as well as your credit utilization ratio.
Disadvantages of debt settlement
On the flip side, the disadvantages of debt settlement could overshadow any potential positives.
- There’s no guarantee your creditors will agree to negotiate
- You could find yourself in more debt from late fees or interest if you stop making payments on your initial debt
- You could face fees from the debt settlement company, regardless of whether they’re able to settle your whole debt
- Your credit score could take a negative hit in the process
- Forgiven debt could be taxable
- Can be time-consuming
Debt settlement alternatives
Using a debt settlement company is one option to settle your debt, but the cost could outweigh the benefit. There are other debt settlement plans that can save you in the long run.
Do-it-yourself debt settlement
Instead of involving a third-party company, you could try settling your own debt. Contact your creditor directly and see if they’ll accept an offer to pay less than what you owe.
If you’re dealing with credit card debt, consider a balance transfer. The goal of a balance transfer is to move a high-interest balance to a new card with a lower annual percentage rate (APR). The best balance transfer credit cards offer a 0% introductory rate for some period of time, usually at least a year, plus no annual fee.
The downside is you may have to pay a balance transfer fee, which can range from 3% to 5%. Some companies will waive the balance transfer fee to entice customers.
Nonprofit credit counseling
You may be able to receive free or inexpensive advice about debt management or budgeting from a nonprofit credit counselor. But these organizations usually won’t work directly with your creditor to settle your debt.
The U.S. Trustee Program maintains a list of government-approved nonprofit credit counseling organizations. If an organization claims to be backed by the government, you can double-check that they’re on the list.
Debt settlement vs. debt consolidation
Debt consolidation is yet another alternative to debt settlement. Debt consolidation is the process of combining multiple debts into one new personal loan with the goal of a lower interest rate. While you may still have to deal with fees, they likely won’t be as high as those associated with debt settlement. Not to mention, debt consolidation won’t hurt your credit score as much.
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