What Is Debt Settlement and How Does It Work?

Debt can be overwhelming, especially if it feels out of control. Maybe you owe more than you think you could ever repay, or your debts are past-due in collections.

Debt settlement may seem like a lifeline in these circumstances, but it’s risky, since it damages your credit, includes costly fees and can take years to complete.

Learn how debt settlement works and compare it with other debt payoff strategies, like credit counseling and debt consolidation.

Debt settlement is the process of negotiating with your creditors and “settling” on a lower amount than you currently owe. It’s usually done with the help of a third party, like a debt settlement company.

Once the creditor accepts the settlement, it can’t continue to hound you for the money, and you don’t have to worry that you could get sued over that particular debt.

Debt settlement gives you a plan for becoming debt-free, which can be a huge relief, but the process can take up to three to four years, and it isn’t always successful.

Debt settlement companies negotiate with creditors on your behalf to reduce the amount you owe on unsecured debt like credit cards, medical bills or personal loans. Debt settlement is not an option for secured debt, like a mortgage or auto loan.

These offers are only enticing to creditors if it seems like you won’t pay at all, so a debt settlement company will advise you to stop making payments on your debts immediately and instead open an escrow account and put a monthly payment there. Once you have enough money saved for a lump-sum offer, the settlement company facilitates the transaction.

Debt settlement isn’t free. Most companies charge a fee of 15% to 25% of the amount you owe. For example, if you owe $10,000, and the debt settlement company charges a fee of 25%, you’ll pay $2,500 once the settlement is complete (in addition to paying the settled amount to your creditor). A debt settlement company cannot collect this fee until it settles your debt.

The Consumer Financial Protection Bureau cautions consumers about debt settlement^[0]

• Your credit will take a hit: Delinquent accounts and settled debts stay on your credit report for seven years, which can make it harder to qualify for affordable credit in the future. 

• Penalties and interest accrue: When you stop making payments on your debts, you’ll likely face financial penalties like late fees. You may also accrue interest, increasing the overall amount you owe. 

• You’ll have to pay a fee when a debt settles: Most debt settlement companies charge a percentage of each debt they settle, based on that debt’s balance when you enrolled in the program. Some charge a percentage of the debt eliminated by the settlement.

• You may pay other fees: In addition to the settlement fee, customers may have to pay other fees, such as a setup fee to open the dedicated escrow account and a monthly fee to maintain the account. 

• Forgiven debt may be taxable: The Internal Revenue Service generally regards forgiven debt as income. You may want to consult a tax professional about additional tax obligations you’ll be taking on if you settle your debt.

• There’s no guarantee of success: Debt settlement doesn’t always work. Not all creditors work with debt settlement companies, and even if they do, they may not accept the settlement offer. Depending on how long settlement takes, the fees and interest that accrue in the meantime may wipe out any potential savings.

Debt settlement can hurt your credit in several ways:

• Missed payments: As you stop paying your debts, your creditors will report these missed payments to the credit bureaus after 30 days. Payment history makes up the largest part of your credit score, so any late or missed payments will hurt your score. 

• Overall debt may increase: As interest accrues on your credit cards, your credit utilization ratio will increase. This ratio measures how much available credit you’re using, and it’s an important factor in calculating your credit score. Typically, the more debt you have in relation to your available credit, the worse your credit score. 

• Collections activity: As your account becomes increasingly overdue, your debt may be turned over to in-house or third-party collections. This debt will be marked as a collections account on your credit report, which can lower your credit score even more, though it may vary based on how much your credit score has already been affected. 

• Settled accounts are reflected on credit report: Settled accounts show you weren’t able to fully pay back what you owed, which is seen as a negative by future creditors. Settled accounts can stay on your credit report for seven years.

Still, paying something may be better than paying nothing at all. If the choice is between not addressing your debt or settling it, debt settlement may be the better option.

1. Research company reviews and look for accreditations

For any debt settlement company you’re considering, do your due diligence by researching online reviews. This can include posts on Reddit or other forum-style websites, as well as checking with the Better Business Bureau to see if there’s a history of complaints.

Financial websites like NerdWallet also maintain reviews of some of the largest debt settlement companies:

• Freedom Debt Relief 

• National Debt Relief

• Accredited Debt Relief

Stick with long-standing companies that have been in business for years and hold outside accreditations, such as from the American Association for Debt Resolution.

2. Beware of upfront fees or false promises

Stay away from any company that tries to collect an upfront settlement fee or guarantees it can make your debts go away for “pennies on the dollar” or a promised reduction amount, says the CFPB. Debt settlement companies also shouldn’t promise they can stop debt collection calls or lawsuits.

Companies should be upfront about fees, terms of service, how long it will take to settle your debts and how much money you need to save before the company makes a settlement offer, according to the Federal Trade Commission.

3. Say yes to the introductory call

Most debt settlement companies offer a no-obligation, introductory phone call as part of their services. Take advantage of this free call to get a feel for how a company does business and ask any important questions you may have, including how much their debt settlement program costs, how it may impact your credit score and the average settlement timeline for customers.

You can try negotiating a settlement yourself, which saves money on fees and may help you get out of debt faster since you control the timeline.

Gather as much money as you can to make a lump-sum offer. This may mean taking a part-time job, selling valuable belongings or other quick ways to get cash.

Though some creditors may be likelier to take a lump-sum offer, which gives them money immediately rather than taking a chance on payments that might not come, other creditors may have a policy against settling debts.

Debt settlement isn’t the only way to get relief from overwhelming debt. Consider these options first before opting into settlement.

Credit counseling

Working with a reputable, nonprofit credit counseling agency is a safer alternative if you have credit card debt.

Credit counselors can help you enroll in a debt management plan, which combines your credit card payments into a single payment with lower interest and gives you a plan to pay off the debt in three to five years. These plans typically come with a one-time setup fee and a small monthly service fee. Unlike debt settlement, debt management won’t cause lasting damage to your credit score.

Debt consolidation loans

Another option is to take out a debt consolidation loan from an online lender or credit union and use the money from the loan to pay off all your debts at once. You then repay the loan at a fixed rate over a set term, usually two to seven years. These loans make the most sense if you can qualify for a lower rate than the average rate across your existing debts.

Since these loans help you pay down the debt in full, they won’t leave a derogatory mark on your credit report like debt settlement. Plus, if you make all payments on time on your new loan, you can even rebuild your credit by showing a positive payment history.

» COMPARE: Best debt consolidation loans for bad credit

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