What is Debt Settlement & How Does It Work?[yoast-breadcrumb]
What is Debt Settlement & How Does It Work?
Debt settlement, also known as debt arbitration or debt negotiation, is a financial tool that can help consumers resolve unsecured debts like credit cards, medical bills, and personal loans. It involves negotiating with creditors or collection agencies to settle debts for less than the full amount owed.
How Does Debt Settlement Work?
The debt settlement process typically involves:
- Stopping payments to creditors – You’ll need to set aside the money you would normally pay towards debts so you can save up funds to make a lump sum settlement offer. This can negatively impact your credit score.
- Negotiating with creditors – Debt settlement companies will contact your creditors and attempt to negotiate a reduced payoff amount, often 30-60% less than what you owe. Creditors are often open to accepting a lower amount to avoid the legal costs of further pursuing the debt.
- Making a lump sum payment – Once a settlement amount is agreed upon, you’ll pay that lump sum payment to the creditor and the remaining balance will be forgiven. Get any settlement agreement in writing before sending payment.
- Having debts reported as “settled” – Settled accounts will be reported to credit bureaus, negatively impacting your credit score. But settled debts are better than defaults. You can ask creditors to report debts as “paid in full” but they are not obligated to.
When is Debt Settlement a Good Option?
Debt settlement can provide debt relief, but also comes with drawbacks. It may be a good choice if:
- You have unsecured debts like credit cards or medical bills
- You can’t afford monthly payments and have defaulted
- You have some lump sum funds available to pay settlements
- You’re okay with the credit score impact
Debt settlement works best for people with limited funds who have fallen behind on payments. If you can still make minimum payments, other options like debt management plans or balance transfer cards may be better.
Pros of Debt Settlement
- Settles debts for less than you owe – Typically resolves debts for 30-60% of the balance
- Provides immediate debt relief – Once settlement is reached, remaining balance is forgiven
- Allows avoidance of bankruptcy – Settlements can help avoid the long-term harm to credit of bankruptcy
- Frees up cash flow – Your monthly payments to creditors are reduced or eliminated
- You can do it yourself – No need to pay a settlement company if you want to negotiate yourself
Cons of Debt Settlement
- Hurt your credit – Settled accounts appear on your credit report and hurt your credit score
- Tax implications – Forgiven debt may be considered taxable income by the IRS
- Accounts could get closed – Creditors may close accounts after settlement is reached
- Payments to creditors cease – Your accounts will go delinquent while you save up for settlements
- Fees if using a company – Debt settlement companies often charge 15-25% of debt amount
- Creditors may sue – You can still get sued for unpaid debts while saving up for settlements
What Debts Can Be Settled?
Debt settlement generally works for unsecured debts that are past due, such as:
- Credit cards – One of the most commonly settled debts. Many card issuers will agree to settlements.
- Medical bills – Providers and collection agencies are often willing to settle medical debts.
- Personal loans – Banks and online lenders may accept settlements for delinquent personal loans.
- Payday loans – Short-term, high-interest payday loans are good settlement candidates.
- Utility bills – Even essential utilities like electricity and water may settle for less.
Debt settlement is less effective for secured debts like auto loans or mortgages where the creditor can repossess the collateral. Student loans also cannot be settled through debt settlement, but do have income-driven repayment options.
What is a Good Settlement Offer?
When making a settlement offer, a good starting point is 25-30% of the total debt amount. Creditors often accept around 30-60% for charge-offs and collections accounts. The more delinquent the debt, the better settlement can be reached.Some factors that influence settlement amounts:
- Age and status of debt – Older and charged-off debts often settle for lower amounts
- State statutes of limitations – Debts past the SOL are prime for settlement
- Your current finances – Documented financial hardship helps negotiate better settlements
- Type of debt – Credit cards tend to settle for less than personal loans
The settlement process is very individualized – there are no guarantees you will get any particular settlement percentage. The key is making reasonable offers and being willing to negotiate.
How Long Does Debt Settlement Take?
The debt settlement process typically takes between 2-4 years from start to finish. It includes:
- 2-12 months of saving and not paying creditors while in settlement negotiations
- 1-6 months for creditors to respond to and accept settlement offers
- 2-4 weeks to send in settlement payments once accepted
- 2-7 years for settled accounts to fall off credit reports
This timeline can vary based on your specific financial situation. Be prepared for a lengthy process – debt settlement provides long-term debt relief but is not a quick fix.
Will Debt Settlement Impact My Credit?
Yes, debt settlement will negatively impact your credit score. Here are some ways debt settlement can hurt your credit:
- Accounts become delinquent – While saving up for settlements, you’ll need to stop paying creditors and accounts will become past due.
- Defaults reported to credit bureaus – After several months of non-payment, accounts will likely be charged off or defaulted.
- Settled accounts appear – Once a debt is settled, it will be reported as “settled” on your credit report.
- Credit score drops – Missed payments, defaults, and settled statuses all lower your credit score. The impact can be 100 points or more.
- Closed accounts – Creditors will likely close accounts once a settlement is reached, reducing your total available credit.
- Difficulty getting new credit – Lenders view settled accounts negatively, making it harder to get approved.
Over time, as the settled accounts age and fall off your reports, the credit impact will lessen. But expect settlement to hurt your score for several years.
Should I Work With a Debt Settlement Company?
Debt settlement companies negotiate reduced payoffs with creditors on your behalf. They charge fees but handle the settlement process for you. Here are some pros and cons of using a company:Pros of Debt Settlement Companies:
- Settlement experience – They have done many settlements and can negotiate effectively.
- Legal compliance – Reputable companies follow laws and regulations.
- Save you time – They handle the negotiations so you don’t have to.
- Stop creditor calls – Once retained, companies will field calls from creditors.
Cons of Debt Settlement Companies:
- High fees – Fees often range from 15-25% of enrolled debt.
- No guarantees – Even with their fees, there is no guarantee settlements will be reached.
- Hurt credit faster – Your accounts go delinquent sooner when you stop paying creditors.
- Scams – Many predatory and fraudulent companies exist.
If using a company, research them thoroughly first with the state attorney general
and the Better Business Bureau
. Get all fees in writing upfront.
What if I Want to Negotiate Myself?
You can absolutely negotiate debt settlements yourself without paying fees to a debt settlement company. Here are some tips to DIY debt settlement:
- Review your finances – Calculate your income, expenses, assets and debts. Document financial hardship.
- Prioritize debts – Focus first on settling debts with the most favorable terms.
- Make lump sum offers – Have funds set aside to make settlement offers in one payment.
- Start low – Begin with offers of 25-30% of the debt amount.
- Get agreements in writing – Don’t send payment until the creditor puts the agreement in writing.
- Follow up regularly – Keep contacting the creditor if you don’t hear back on an offer.
- Be willing to negotiate – Debt settlement is a back and forth process.
- Seek help if needed – Nonprofit credit counselors can provide guidance on the process.
With patience and perseverance, you can negotiate directly with creditors just like a debt settlement company would.
Can Debt Settlement Hurt My Credit Score?
Yes, debt settlement can significantly hurt your credit score for several years. Defaulting on accounts, having debts charged off, and settling for less than owed will all show up on your credit reports and drag down your credit scores.Missed payments also hurt your credit utilization ratio, which measures how much of your total credit limits you are using. Settling and closing accounts lowers your total credit limit, increasing your utilization.