How Does Debt Settlement Work? What You Need to Know

If you’re struggling with debt, debt settlement might be the solution. According to a report from the Federal Reserve, borrowing has reached record highs, and outstanding consumer credit now totals $4.7 trillion.

Debt settlement is a form of debt relief that involves negotiating with your creditors and debt collectors to reach an agreement to accept a payment for your unsecured debts that is less than the total amount you owe. While it may not be the cheapest way to get out of debt, hiring a debt settlement company can often be the best option to solve your problems if you owe more than $10,000 in unsecured debt.

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Debt settlement may solve your problems

It’s not openly publicized, but many lenders are willing to accept even half of what you owe. You can call the creditor directly and negotiate your own settlement deal, or you could also choose to hire a third-party company to negotiate on your behalf. Most unsecured debts can be settled, including many private student loans. However, creditors have no legal obligation to settle for less, and it will affect your credit score, at least initially.

Pro tip: Settlement involves negotiating with creditors and then repaying the creditor with either one lump-sum payment or a series of payments over a specific term. Therefore, there’s not much point in attempting to settle debts on your own if you don’t already have money stashed away to prove you can make the payments. Many debt settlement companies will first set up a savings account and have you deposit money into it until enough has been accrued to make a settlement offer. Having money to back up your offer increases the chances of reaching a settlement deal.

READ MORE: Do you feel like you’re drowning in debt? Learn how to save yourself

Are you eligible to settle your debts?  

While these aren’t necessarily requirements, it’s worth considering debt settlement if one or more of these applies to you:

  • You have more than $10,000 in debt and are only making the minimum payments with no headway
  • You can’t keep up with your current debts
  • You’ve already missed more than three consecutive monthly payments
  • You have at least one charged-off debt on your credit reports
  • You are overwhelmed by your financial situation
  • You’re facing financial hardship
  • You’re constantly paying late fees from juggling so many bills
  • Most of your debt is made up of unsecured loans
  • You are committed to a long-term plan to repair your finances

Learn how much debt settlement can save you by using the calculator below.

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READ MORE: Debt settlement — how to get your debt under control now

Pro tip: Be aware that most creditors will only agree to negotiate a settlement after the debt has been charged off. If you think a settlement is your best solution, stop making payments and put that money in a savings account instead. That way, you’ll have money to offer during the settlement negotiations.

READ MORE: When is debt settlement a good idea?

Which debts are eligible for settlement? 

There are two types of debt, secured debt and unsecured debt. Secured debt is backed by collateral. These include mortgage loans and auto loans. Unsecured debt involves no collateral. Credit card bills, student loans, and medical bills are examples of unsecured debt. Only unsecured debts are eligible for settlement.

However, not all forms of unsecured debt will be eligible. Child support, alimony and tax debts cannot be settled.

Pro tip: Don’t fall behind on your other obligations simply to settle a different debt. Try to stay up-to-date on your monthly bills, particularly for any car loan or utilities.

READ MORE: Debt settlement qualifications

How debt settlement companies work

Debt settlement companies, sometimes called debt relief companies, are for-profit companies borrowers can hire to handle the debt settlement process. They help negotiate principal reductions on your credit cards or with other creditors. In general, the company will charge somewhere between 15% to 27% of the total debt that is settled. The American Association for Debt Resolution reported that the average consumer sees savings of 30% on the original debt, including fees. Before any fee is charged, the customer must agree to and make a payment toward the negotiated settlement.

Pro tip: The American Association for Debt Resolution was previously known as the American Fair Credit Council.

A legitimate debt settlement company will not ask you to pay upfront fees.

When enrolling with a debt settlement company, you will be asked to stop paying your creditors. You will place money in a separate account, which may include a maintenance fee. Once the account has grown to a certain amount, which can take months and sometimes up to a year, the debt settlement company will negotiate a settlement offer. Once a settlement agreement is reached, a lump-sum payment or a term settlement will be made to the debt collector or creditor to settle the account.

READ MORE: Debt settlement companies

Pro tip: Unfortunately, there are a lot of debt settlement scams. Vet any debt settlement company thoroughly through the Better Business Bureau and your state attorney general’s website to ensure they are reputable. The most obvious sign of a debt-relief scam is if the person or company offers to help get rid of your debt by first paying them an upfront fee or guaranteeing a settlement outcome. The debt settlement industry is heavily regulated by the Federal Trade Commission (FTC). If something seems suspicious, cut off communication and find a different company.

DIY debt settlement: How it works

You do not have to use a debt settlement company to handle your negotiations.

If you are willing to educate yourself and have the time available, you can handle your debt negotiations independently. You must be a skilled negotiator to get the best deal with your creditors.

Once you’ve established a savings account, call your creditor or the debt collection agency and make a settlement offer. Start somewhere around 15% of the total you owe (though be aware that it’s unlikely that your initial offer will be accepted.)

When you reach an agreement, get it in writing. This will be the most affordable way to get out of debt.

Pro tip: Be aware that creditors are not legally required to settle. It’s possible that your lender will not be willing to negotiate. One of the benefits of using a for-profit debt settlement company is that they will already have an idea of which creditors are willing to consider settlements.

READ MORE: Step-by-step guide to DIY debt settlement

How long will debt settlement take? 

Typically, the debt settlement process takes between two and five years.

The debt settlement process depends on your total debt and how many different lenders you owe. For a professional debt settlement program to succeed, you must stick to the agreed-upon payment plan to build enough funds to negotiate a settlement agreement.

READ MORE: Debt settlement pros and cons

Debt settlement will affect your credit score

First, your credit score is probably less than ideal if you’re considering debt settlement. You already likely have established a pattern of missed payments. It may get a bit worse before it gets better. This is because many debt settlement companies will ask you to stop making your monthly payments until a settlement deal has been reached.

When you stop making payments, those will be noted on your credit report, and your credit score will initially fall. The damage won’t be permanent, though. Once the debt is paid off, your credit score will start to recover.

Also, a debt settlement plan modifies or negates your original loan contract, which will affect your credit score. Your credit report will mark any settled debt as “paid as settled.” Again, that damage won’t be permanent. With time and patience, your score will get back on track.

Pro tip: Any damage to your credit score will still be less than if you file for bankruptcy or the debt is reported as charged off. Part of the reason creditors are willing to make settlement deals is that if the borrower files for bankruptcy, the lender gets nothing. With debt settlement, at least the creditor gets a partial payment.

READ MORE: How will debt settlement affect your credit score?

What happens after debt settlement? 

When your debt settlement program is complete, you will have “paid as settled” noted on your credit report. “Paid as settled” indicates that you repaid less than you borrowed. The “settled” notation should not directly affect your credit score, though potential employers and landlords will be able to see that you didn’t fully repay your obligations.

After the payment is complete, your credit card company will close the account due to a contract modification, which will affect your credit utilization ratio, accounting for 30% of your credit score. You may need help (a co-signer, for example) to secure new credit until your credit score rebounds. It won’t take the full seven years before your credit history starts to recover, but it will take some time. You’ll just have to be patient and strategic.

Pro tip: Pay your existing debts on time and lower your credit utilization ratio to improve your credit. Combined, these two components account for 65% of your score. Focus on improving your debt-to-income ratio and get it below 43% before approaching lenders.

READ MORE: Do you need a debt settlement attorney?

There may be tax implications

After settling your debts, be aware that there could be tax implications from the IRS, as they can view any fixed debt as taxable income. If your settlement results in a debt reduction of $600 or more, the creditor must notify the IRS, and the accommodation may be included as part of your taxable income. However, there are exceptions, particularly if you can show financial hardship. You will need to talk to a tax adviser to be sure you fully understand the implications of any settlement agreement.

READ MORE: Debt settlement fees

Other debt relief options 

Other debt relief options are credit counseling and getting on a debt management plan, debt consolidation via a personal loan or balance transfer card, or filing for bankruptcy, which should always be viewed as a last resort. 

  • Balance-transfer credit cards: Balance transfers are a great option if your credit is good. Apply for a new credit card with an introductory APR of 0%. Then transfer your high-interest debts to the new card. You’ll pay a balance transfer fee, but you can save quite a bit of interest if you can pay off your new card within the promotional period — usually 12 to 18 months. Some balance transfers on credit cards even offer 0% rates, and you can transfer up to 80% of your total credit line.
  • Credit counselors: Some nonprofit credit counseling agencies can help you establish a budget to manage your debt. Credit counselors can work with consumers to create a budget and develop a Debt Management Plan. A Debt Management Plan will not typically have tax implications since the consumer repays the total debt owed. Credit counseling agencies can negotiate with your lender to lower the interest rates to help resolve your debt. You still pay the total amount of the principal, so your credit score will be higher than if you’d settled the debt. There is a small monthly fee charged for a debt management plan. The cost usually ranges from $25 to $55 per month.
  • Debt consolidation: A debt consolidation loan is a personal loan used to pay off unsecured debt. Instead of balancing the repayment of multiple debts, you can have the debt moved into one loan that may have a lower interest rate than what you previously paid.
  • Debt snowball method: The “snowball method” means paying off the smallest of your loans first. Once your smallest debt is repaid, you take the money you were putting toward that payment and roll it onto the next-smallest debt owed. Ideally, this process continues until all accounts are paid off. Paying off debts with the smallest balances can be a motivator.
  • Debt avalanche method: In the debt avalanche method, you pay your debts from the highest interest rate to the lowest interest rate, regardless of balance. The avalanche method doesn’t give you the same instant gratification that the debt snowball method does, as it typically takes longer to eliminate your first debt. However, the avalanche method will save you time and money in the long run, as your debts will be paid off faster and accrue less interest than the snowball method.
  • Bankruptcy: If your debt problems are so severe that you simply don’t see any other solution, bankruptcy can offer a fresh start. There are two primary types to consider: Chapter 7 or Chapter 13. Chapter 7 is the most common type of bankruptcy, but not everyone will qualify.

READ MORE: Debt relief programs

The bottom line

Debt settlement can often be the best way out of your financial predicament. Just make sure to research any company that catches your attention carefully, read customer reviews and complaints, and, above all, understand that the relief will not be instant.

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