How Does Debt Settlement Work?
Debt settlement can help you get out of a tight spot when the bills are piling up, but it isn’t risk-free. This process can negatively impact your credit score, likely lowering it by up to 100 points or more. It can also come with steep service fees.
This guide will walk you through the debt settlement process, including its benefits, disadvantages and tips on how to settle debt yourself.
What is debt settlement?
Debt settlement, also known as debt relief, is the process of negotiating with creditors to settle your debt for less than what you owe.
Debt settlement can be an attractive option for individuals who are having trouble keeping up with their monthly payments. However, it isn’t an easy way out of debt obligations. On the other hand, it should be considered a last resort since the process isn't guaranteed and it can damage your credit history.
Also, note that debt settlement is only available for unsecured debt, such as credit cards or personal loans. Secured debt, like mortgages and auto loans, doesn’t qualify.
How does debt settlement work?
Debt settlement requires offering creditors a lump sum that’s less than the total you owe but enough to convince them to settle the debt rather than risk not receiving any payments at all. The process typically involves hiring a debt settlement company to negotiate with creditors on your behalf.
To entice creditors to settle, debt settlement companies ask you to stop paying creditors and instead make monthly payments to an escrow account. The company will manage the account and use the funds to pay off your debt once an agreement is reached. It’ll also use the money to cover its service fees, which can be up to 25% of the original debt amount.
Is debt settlement a good idea?
Debt settlement is not always the best option to get out of debt. The process is not guaranteed and might take up to four years, during which your credit history will get damaged because you’ll stop making monthly payments.
Also, if your creditors don’t agree to settle, you could end up owing even more money in the end due to late fees and interest.
Below we’ll mention the benefits and risks you should keep in mind before signing up for a debt settlement program.
Debt settlement pros and cons
Pros
- Your total debt may be reduced by as much as 50%
- It can potentially help you avoid bankruptcy
- Debt collectors will stop calling if your creditor agrees to settle the debt
Cons
- Not all creditors are willing to negotiate with debt settlement companies
- Even if creditors are open to hear debt settlement offers, there’s no guarantee they’ll accept
- Debt settlement companies charge high fees (up to 25% of the amount you owe creditors)
- Companies may charge monthly fees to manage your escrow account
- As the settlement is negotiated, your debt will continue accruing interest charges
- Debt settlement companies will encourage you to spot making monthly payments, which will damage your credit history
- Settled accounts will be a negative mark in your credit report for seven years
- The Internal Revenue Service (IRS) will charge you taxes on the forgiven balance
How to negotiate debt settlement on your own
If you want to avoid the high service fees of a debt settlement company, you can try to negotiate a settlement on your own. Negotiating a debt settlement on your own involves:
- Starting a settlement fund
- Saving up enough to offer creditors a lump sum
- Making an offer to your creditors
- Agree to a settled amount in writing
- Paying off the agreed amount
Even though the process seems straightforward, keep in mind that most creditors are not willing to settle accounts unless you’ve missed several payments. However, you should always try to pay your debts on time whenever possible, even if only the minimum payments, to prevent harming your credit score.