- Debt settlement is the process of using a third-party company to negotiate down your debts and clear any related legal actions brought against you by lenders.
- Debt settlement often comes with numerous fees, involves damaging your credit score, and can do more harm than good.
- There are a number of resources available, like credit counseling and debt consolidation, that can help you clear debt with fewer risks and pitfalls than debt settlement.
If you’re faced with personal debt, you’re not alone. In fact, for Americans, the average personal debt (meaning debt excluding mortgages) is now estimated to be roughly $38,000.
Debt relief is likely at the top of your mind if you have debt. While it can be tempting to take any debt relief that comes your way, do extensive homework to ensure you don’t fall into an even deeper hole. In this article we’re tackling debt settlement, which sounds harmless enough. But, is it?
What Is Debt Settlement?
Debt settlement, also referred to as debt negotiation, debt arbitration, and credit settlement, is the reduction or complete payoff of your debt. The process sounds straightforward, but can actually get quite messy, very quickly.
Let’s look at how debt settlement works to get a clear idea of what’s at play here.
How Does Debt Settlement Work?
Debt settlements are handled by a debt settlement company, and the process generally works like this. This company will act on your behalf once you give them the name of the creditors you owe money to. From there, the settlement company will look at your total debt, come up with an estimation, and tell you how much you’ll owe the company. At this point, as part of your debt settlement plan, you’ll stop paying the creditors you owe money to and instead pay the settlement company.
The money you pay the debt settlement service will go into a savings account. When it reaches a certain point, the settlement company will contact your creditors and negotiate to pay down your debt at a fraction of the total balance. If successful, they’ll let you know how much you owe and tack on their fee.
Essentially, the debt settlement company will typically promise to get your debt reduced in many cases, meaning you only pay whatever amount they set forth in your debt settlement program. So, what’s the catch?
Should You Use Debt Settlement?
Debt is a serious topic that requires serious work to clear out. Debt settlement sounds like a great cure-all, but the process comes with risks to you, chief of which are:
- Numerous fees: Debt settlement companies are out to make profits, like all businesses. There’s almost always a fee associated with debt relief companies, and they intend to collect on this fee whether they are successful or not. This fee can be a fixed rate or percentage based on the amount of your debt. Either way, the fee can be large and quickly undo some of the debt that was supposedly forgiven by their negotiations.
- Credit score hit: It’s rare for creditors to negotiate a lower interest rate or debt balance. That is, unless your account is already many months overdue. This means you typically have to let your accounts have an outstanding balance that rides without any payments for some time. Skipped payments can do a serious number on your credit score, no matter the amount of debt. This also means your debt often gets sent to a collection agency, which results in collection calls from debt collectors. Think carefully if either scenario is something you, and your family, are prepared for.
- Additional interest can accrue: The entire time you’re waiting to reach a settlement, your accounts are gaining interest. Not only this, your accounts also gain interest even after the agreement has been reached, meaning you can still wind up paying a small fortune in interest.
- Creditors may not budge: Even if you allow your account to become delinquent, and even after the debt settlement company has given them their best negotiation, the creditors may not budge on the debt amount. This means you can end up with a damaged credit history, a higher debt amount, late fees, and an even steeper hill to climb before you’re debt-free. Remember: There’s no guarantee the debt settlement process will reduce your debt.
- Tax implications: When you have any debt forgiven, the Internal Revenue Service (IRS) treats this as income. This results in you having to pay income taxes on the forgiven debt. Depending on the debt amount, this can be a sizable chunk to come up with at tax time, and the IRS has the authority to garnish your wages.
- Your credit will take a seven-year hit: If you successfully settle your debt and pay it off, your credit score will have a seven-year mark on its record. This can result in poor access to loans and credit cards, and sky-high interest rates for those seven years as you rebuild your credit.
There may be better options for you to consider than debt settlement. The relief debt settlement offers can be an illusion, considering the drawbacks and risks, and can actually result in more harm than good. When you factor in the hit to your credit score, the fees of a relief service, the income tax and the stress, debt settlement can end up costing you even more than the original total debt in some cases.
To help you get on the path to freedom from debt, let’s look at some alternatives to debt relief services.
Alternatives to Debt Settlement
Not all debt relief carries the same risk as debt settlement. In fact, many debt relief options and debt management services are helpful and free in some cases. Here are some options to explore if you’re feeling your debt isn’t decreasing no matter how hard you try:
- Debt consolidation: If you have numerous credit cards or loans, you may qualify for a debt consolidation loan. This process involves going to a lender and getting a loan for the total amount you owe across your credit cards or other accounts. The loan will typically have a better interest and longer term, meaning your monthly payments are smaller. This one loan is then used to pay off all of your debt, leaving you only with the fixed monthly payments on the debt consolidation loan. This approach will only work if you finally cap your personal debt and curb the spending that led you here.
- Credit counseling: A credit counselor can give you financial advice that’s tailored to fit your situation. From there, they can help you set up a repayment plan that doesn’t involve skipping payments, discuss any additional relief options that may be available, and provide ongoing support as you pay down your debt. They can even give you a general debt management plan that helps you stay on the right path moving forward.
- Call your credit card company: It might sound simple, but you can call your credit card company and try negotiating a lower interest rate. In some extreme cases, the company may even reduce the total sum you owe, especially if your credit rating is still decent or your payments have been timely.
Can You Settle Debt With a Collection Agency Yourself?
If you’re still curious about trying to settle debt but you want to avoid a debt settlement service, you can try settling with your creditors or the collection agency yourself. This is rare, as the process is lengthy and time-consuming, but it’s not entirely impossible either. The following steps outline the process for attempting to settle your debt with a collections agency. As always, consult with a financial expert before making any calls.
- Total up your debts owed: First things first, you need to look at how much you owe. You also need to see who you owe each sum to, if you have more than one debt to settle.
- Save up a lump sum: Creditors can be understanding, but even still a lump sum can go a long way. Save up what you can ahead of time just in case a creditor requests a lump sum payment to clear your debt. (This can also be a nice bargaining chip during your call.)
- Pay what you can ahead of time: While you’re saving up, cut back on spending where you can and try to pay off as much of your existing debt as possible. This can show creditors that you are making an effort to pay off your debt, and go a long way when it comes to reasoning with them. At the very least, keep up with the minimum monthly payments due on each debt to protect your credit score.
- Create an offer for each creditor: Write out an offer for each creditor your owe money to. It’s not unheard of for creditors to accept offers that are less than half of what is owed, but they can take upwards of two months to reply.
- Prepare counteroffers: Creditors can and will turn down your offers if they want. Always be prepared to make counteroffers if this happens. They may not budge, but it’s worth trying if you’ve gotten this far.
- Pay your debt and get it in writing: Once you’ve gotten creditors to agree to an amount, pay it off as quickly as you can and ask that they give it to you in writing that you’ve paid off your debt. Make sure this note is signed by an agent from the creditor, as this can be used in the event anyone claims your debt hasn’t been settled. Think of this like a doctor’s note for an excused absence.
After reviewing all of these steps you may still feel a debt settlement company is a better option than trying to do it yourself. If you decide not to go with these alternatives and intend to use a settlement company instead, review its reputation ahead of time. There are fraudulent companies out there that will take your money and do little in the way of helping.
With prep work, determination, and perseverance you can pay off your debts. There are a number of routes you can take and numerous resources at your disposal if you’re willing to ask for help.
An important part of this process is to address the spending situation that got you into debt in the first place. If the root of the issue doesn’t change, you’ll risk falling back into a pit of debt even after settlement. Establish smarter spending habits, learn to budget, and take back control so that you can truly be debt-free.