Debt Settlement: Pros and Cons of Settling Debt for Less[yoast-breadcrumb]
Debt Settlement: Pros and Cons of Settling Debt for Less
Debt settlement can seem like a great option when you’re drowning in high-interest credit card balances and other unsecured debts. The promise of settling your debts for pennies on the dollar is enticing. But debt settlement also comes with risks and downsides you need to consider.
In this article, we’ll walk through the ins and outs of debt settlement – how it works, the pros and cons, and whether it’s likely the best path forward for your situation. We’ll also touch on some alternatives like debt consolidation loans and credit counseling that may better fit your needs.
What Is Debt Settlement?
With debt settlement, you work with a debt settlement company to negotiate down the total balance you owe to creditors. The debt settlement company contacts your creditors and attempts to get them to agree to let you pay a smaller lump sum – say, 30% to 50% of your total balance – and consider the rest settled.
Debt settlement companies often advertise very high settlement rates, sometimes up to 50% or more off your balances. However, there’s no guarantee your creditors will agree to settle – they may hold out for the full amount due.
How Does Debt Settlement Work?
Here’s a quick rundown of the debt settlement process:
- You sign up with a debt settlement company and pay enrollment fees.
- You stop making payments to your creditors so you can save up settlement funds.
- With guidance from the debt settlement company, you start negotiating settlement offers with creditors.
- Once a creditor agrees to settle, you pay the negotiated amount as a lump sum.
- The creditor considers the debt settled and stops collections activity.
Let’s unpack what happens in more detail:
1. Enrolling in a Debt Settlement Program
First, you have to find and vet a reputable debt settlement company to work with. Debt settlement companies typically charge an upfront fee to get started, often several hundred to a few thousand dollars.
Some debt settlement companies also take a percentage of the debt amount as their fee – for example, 25% of the total enrolled debt. So on $20,000 of debt enrolled, they may charge $5,000.
2. Stopping Payments to Creditors
Once enrolled, you’ll stop making regular payments to your creditors. Instead, you’ll start depositing monthly payments into a dedicated savings account. This account will be used later to fund the lump sum settlement offers.
With no more payments coming in, your accounts fall further behind. Your creditors may charge late fees and penalty interest rates. They’ll also start collection calls and letters demanding payment.
3. Negotiating With Creditors
After several months of saving, the debt settlement company will start negotiating with your creditors. They’ll offer lump sum settlements – say, 50% of the amount owed – and ask for the rest to be forgiven.
Creditors are under no obligation to accept a settlement offer. They may counter with a higher amount or refuse to settle altogether. A debt settlement company typically won’t take no for an answer and will keep negotiating to get the lowest settlement possible.
4. Paying the Settlement Amount
Once a creditor agrees to a settlement, you’ll tap the dedicated savings account to pay the lump sum owed. The creditor will then consider the debt settled and stop all collections against you.
Ideally you’ll have enough saved to settle all your debts enrolled in the program within 24 to 48 months. If the process drags on too long, you risk getting sued by creditors before balances can be settled.
Debt Settlement Pros
Settling debt for less than you owe has some potential benefits. Here are some of the main pros of debt settlement:
Pay Less Than You Owe
This is the big draw of debt settlement. By accepting a lump sum that’s less than the full balance, creditors recoup more money than they would if you end up filing bankruptcy. Settlements typically range from 30% to 60% of the amount owed.
Rather than spending years chipping away at balances through minimum payments, debt settlement lets you resolve accounts with a single lump sum. This can help you get out of debt much faster.
Settlements Are Negotiable
Debt settlement gives you some bargaining power with creditors. They may start with a high settlement percentage but come down on the amount if some money is better than none.
Stop Collection Calls and Lawsuits
Once an account is settled, the creditor writes it off and stops all collections activity. No more stressful calls and letters demanding payment.
For some consumers facing truly unmanageable debt, bankruptcy starts to look like the only option. Debt settlement provides an alternative that doesn’t involve filing bankruptcy.
Debt Settlement Cons
Debt settlement can be risky and may create as many problems as it solves. Here are some potential cons to watch out for:
Settlements Aren’t Guaranteed
Creditors have no obligation to accept a settlement offer, even if it comes from a debt settlement company. You may go through months of hardship only to end up right back where you started.
Fees Can Be High
Between enrollment fees and a percentage of debt fees, debt settlement companies make their money whether or not your debts actually get settled. All those fees just add to your overall debt burden.
The IRS may consider any amount of debt forgiven through settlement to be taxable income. You could get stuck with a big tax bill.
Your Credit Will Suffer
Not making payments will cause severe damage to your credit scores. Accounts in settlement may be noted as “settled for less than full balance” on your credit reports.
Continued Collection Efforts
Your creditors don’t stop collection activity just because you enrolled in a debt settlement program. You’ll still get the calls, letters, and potential lawsuits until each account is successfully settled.
Coming up with one large lump sum to settle an account can be difficult. If you can’t fund the settlements, your creditors may back out of the deals and resume collections.
Risk of Lawsuits
Aggressive creditors may decide to sue you to recover the debt rather than wait around for a settlement. If they win a judgment, they can garnish your wages or put liens on your property.
When Does Debt Settlement Make Sense?
Debt settlement works best for certain types of consumers in particular situations:
- You have high-interest unsecured debt like credit cards, medical bills, or personal loans.
- You have some funds available to save up for settlements.
- Your income is too high to qualify for bankruptcy or other alternatives.
- You’re facing financial hardship but want to avoid bankruptcy.
Even then, debt settlement carries risks and downsides. But for some consumers in truly dire straits, it can be a financial lifeline.
Debt Settlement vs. Debt Consolidation
Debt consolidation is commonly brought up as an alternative to debt settlement. With debt consolidation, you take out a new loan at a lower interest rate and use it to pay off your existing debts.
This effectively combines multiple debts into one, lower monthly payment. Debt consolidation loans are available from banks, credit unions, and online lenders. You can also do a balance transfer to a 0% APR credit card.
Compared to debt settlement, consolidation has some benefits:
- You keep making payments, so you avoid late fees and penalty interest rates.
- Your credit score won’t take as big of a hit since accounts remain in good standing.
- Interest rates are usually lower with debt consolidation loans.
- You get a fixed monthly payment instead of juggling multiple payments.
- No tax consequences for forgiven debt amounts.
However, debt consolidation also has some downsides to consider:
- You extend your payoff timeline by several more years.
- Missing payments can still hurt your credit and lead to fees.
- You may end up paying more interest over the long run.
- Lenders often have strict eligibility requirements.
Overall, debt consolidation can be a less risky option than debt settlement. But it works best for certain types of borrowers, like those with good credit scores and steady incomes. It offers a structured way to streamline multiple debts into one manageable payment.
Debt settlement, while riskier, may make more sense if you have very high debt relative to income or have already fallen far behind on payments. By settling for less than you owe, you can resolve debts in a fraction of the time.
Every situation is different. Consider both options as well as credit counseling to decide which debt relief strategy aligns best with your financial situation.