What is Debt Settlement and How Does it Work?
Debt settlement is when you make an agreement with a creditor to pay off your debt for less than the full amount owed. It can provide debt relief, but also comes with risks. This article will explain how debt settlement works, pros and cons, and things to consider before trying it.
When to Consider Debt Settlement
Debt settlement may be an option if you have a lot of unsecured debt like credit cards or medical bills, and can’t keep up with minimum payments. Some signs debt settlement could help:
- You owe $10,000+ in credit card or other unsecured debt
- Your income doesn’t cover all your monthly payments
- You have accounts that are past due or in collections
Debt settlement probably isn’t a good fit if you can still make payments, have assets creditors could seize, or have secured debt like a car loan.
How Debt Settlement Works
Debt settlement involves contacting creditors and offering to pay a lump sum that is less than what you owe in exchange for wiping out the debt. For example, settling a $10,000 balance for $4,000. Creditors agree because they get a portion of what is owed quickly, instead of you defaulting completely.
You can negotiate debt settlements yourself by calling creditors and making offers. Many people hire a debt settlement company to handle negotiations for them. The company charges a fee, often a percentage of debt settled.
The debt settlement process typically takes 2-4 years. You stop making payments and let accounts fall behind so creditors are motivated to settle. The company negotiates lump sum settlements, and you save up to pay them. Once the new payment terms are agreed to, the debts are considered settled.
Pros of Debt Settlement
Some potential advantages of debt settlement include:
- Settling debt for less than you owe
- Consolidating multiple debts into one payment
- Avoiding bankruptcy
- Stopping collections calls and lawsuits
If done successfully, debt settlement can resolve unmanageable debt and provide a fresh start.
Cons of Debt Settlement
There are also disadvantages and risks to weigh:
- Hurt your credit – Accounts will become delinquent and show “settled” status
- Pay fees to a debt settlement company
- No guarantee creditors will accept offers
- Still owe taxes on amount of debt forgiven
- Creditors can still sue within statute of limitations
Debt settlement can leave you worse off if creditors won’t negotiate and you rack up fees. Be prepared for a credit score drop up to 100 points or more.
Alternatives to Debt Settlement
Before choosing debt settlement, also consider:
- Credit counseling – Nonprofit agencies offer free counseling and debt management plans
- DIY settlements – Negotiate with creditors yourself for free
- Debt consolidation loan – Combine debts into one with lower interest
- Bankruptcy – Court supervised process to eliminate eligible debt
Each option has pros and cons to weigh based on your situation. The best approach gives you long-term financial relief.
Finding a Reputable Debt Settlement Company
If hiring a debt settlement company, choose carefully since some engage in scams and abusive practices. Warning signs include:
- Charging substantial fees before settling any debts
- Telling you to stop communicating with creditors
- Guaranteeing they can eliminate debt
- Telling you to stop making payments to creditors
Look for a company accredited by organizations like the American Fair Credit Council (AFCC) or the International Association of Professional Debt Arbitrators (IAPDA). Get everything in writing first.
Is Debt Settlement Right for You?
Debt settlement can provide debt relief, but also comes with credit damage and other risks. It works best for those with high unsecured debt burdens and limited income to repay what they owe. Consider all options and speak to a credit counselor before deciding if it is your best path forward.