Debt Settlement Basics: What You Need to Know About This Debt-Relief Option
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In most cases, debt settlement should only be considered as a last resort or at least the last possibility before declaring bankruptcy. This article explains what debt settlement is and will help you decide when you’d want to do it yourself and when it may make more sense to hire a professional to do it for you.
Written by Mark P. Cussen, CMFC.
Updated October 19, 2021
If you’re up to your eyeballs in debt and your financial situation is looking bleak, then you have a few options. You can declare bankruptcy, but this will stay on your credit report for the next seven years. You can take out a debt consolidation loan, but this can be expensive. Or you can try to settle your debts with each of your creditors for less than what you owe them. This article explains what debt settlement is and will help you decide when you’d want to do it yourself and when it may make more sense to hire a professional to do it for you.
How the Debt Settlement Process Works
The first thing that you need to understand about debt settlement is that it only works with certain types of debt. Unsecured debts, such as personal loans, medical bills, credit card debts, department store charge cards, and other similar types of debt are eligible for debt settlement. Debt settlement is not an option with any type of secured debt, such as a car loan, mortgage, or a student loan subsidized by the federal government.
You may be wondering why a lender would even consider a debt settlement offer if it means they’ll be getting back less than the full amount you owe. The truth is, most unsecured creditors, such as credit card companies, would rather recoup a portion of their money rather than get no money back at all. But the timing here matters. Creditors allow borrowers to make debt settlement offers as a last-ditch effort to receive something from you instead of nothing. So in most cases, your account must be well past due before your creditor will be willing to consider debt settlement. Most creditors will not negotiate on an account that’s current.
You can negotiate a debt settlement on your own or hire a company to do it for you. Most debt settlement companies will advise you to stop paying your creditors directly to increase their willingness to negotiate. During negotiations, they will propose a settlement amount that is less than the full amount you owe. The creditor can accept or reject this offer at their discretion. They are under no obligation to negotiate. But if the creditor sees you are in a financial position that prevents you from meeting your financial obligations, they may accept a settlement offer. Once you pay the settlement amount, the creditor will forgive the rest of your debt and won’t come after you for it.
If you choose to settle your debts on your own, you will have to negotiate with each of your creditors individually. The amount of debt each creditor forgives will often depend on your ability to negotiate successfully. If you can prove that you are completely unable to continue making your debt payments, then the creditor may be willing to settle for nothing. But they always have the final say about whether or how much of your total debt they are willing to forgive. While it’s possible to clear all your debt through settlements, studies have shown the odds for this are low.
How Much Will I Have To Pay?
If you become delinquent enough with your unsecured debt and miss enough payments, then your creditor will usually either charge off your debt or sell it to a debt collection agency. But the debt collection agency will only pay your creditor a few cents for every dollar of your outstanding debt. If they think they can get more money from you via a settlement than they will get by selling or consigning your debt to a third-party vendor, they’ll have a good incentive to settle.
You may be required to make a lump-sum payment to the creditor as part of your settlement agreement. Or they may be willing to let you make a series of payments. In this case, you may have to pay interest, but you can also negotiate this interest rate. The target amount for a typical settlement is 40%-60% of the original amount, although this varies. You may be able to get your creditor to forgive 80% of your debt in some instances, while other creditors may only be willing to forgive 20% of your debt. There are no federal or state regulations guiding this process. So it’s largely dependent on your ability to negotiate in most cases.
How Long Does the Debt Settlement Process Take?
If you choose to hire a debt settlement company to handle your debts, it could take months or years to settle your debt. This is because many debt settlement companies require you to make monthly payments into a savings account until you have saved enough for the company to offer the creditor a lump-sum payment. In the meantime, since you’re not making payments to the creditor, your credit score will be damaged.
If you negotiate directly with your creditors, the process may be faster, but you’ll also need to be prepared to come up with the money quickly for a lump sum payment.
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What Are the Consequences of Debt Settlement?
Although it feels good to settle your debts for less than what you owed, in most cases, there will be tax consequences. Most creditors that settle with you will send you a Form 1099-C at the end of the year. This form will list the amount of debt the creditor forgave. The amount you owe minus the amount you paid in the debt settlement equals the amount the lender forgave. You have to report this forgiven debt as taxable income on your income taxes if it is $600 or more.
Debt cancellations are always taxed as ordinary income, which means that you’ll pay taxes on this debt at your top marginal tax rate. This is the case for any amount of forgiven debt that exceeds $600. This limit applies on a per-debt basis. If you have four separate creditors who forgive you $500 each in one year, you may not get any 1099-Cs in the mail and won’t owe taxes on the forgiven debts.
There can also be consequences to your credit score. The late payments and late fees leading up to the settlement will be reported on your credit report and have a negative impact on your credit score. Charge-offs and accounts that are sent to collections will also damage your score. And debt settlement itself will also usually drag your score down. You may also continue to get collection calls until you have paid your settlement amount in full. So if you decide to settle your debts, be aware of the long-term consequences that will come with this strategy.
Debt Settlement Company or Do-It-Yourself?
While debt settlement companies may have more experience negotiating with creditors, at the end of the day, there is nothing that a debt settlement company can do for you that you can’t do for yourself. But negotiating with creditors does take time and energy. So hiring a debt settlement company may be a wise choice if you’re busy with work or other obligations and don’t have the time or desire to deal with debt settlement directly.
Hiring a Debt Settlement Company
The debt settlement company will contact your creditors and negotiate on your behalf. You won’t have to lift a finger. But this comes at a cost. Debt collection companies are for-profit entities, and they can be expensive. They may charge as much as 15%-25% of the total amount of debt that you owe. They may also charge enrollment or setup fees. Consider the total cost of paying for a debt settlement company before deciding if you’re better off negotiating directly with your creditors. Also, keep in mind that some creditors are unwilling to negotiate with debt collection companies.
Let’s say you have $100,000 of credit card debt and your creditor charges you $25,000 to reduce the amount you owe to $50,000. In this case, you’ve come out ahead by $25,000. While this may be acceptable for some, others may want to try to negotiate directly with their creditors instead. You may be able to bargain your way to a similar settlement amount without having to fork over all that money to a debt settlement company.
In addition to the costs, another drawback of using a debt settlement company is that many aren’t reputable. Be sure to do your homework before signing on the dotted line because this industry is rife with scams, fraud, and deception. There are many disreputable debt settlement companies that have had complaints filed against them. With some research, you can find these complaints. Check with the Better Business Bureau (BBB), the Federal Trade Commission (FTC), the Consumer Financial Protection Bureau (CFPB), and your state attorney general’s office before signing up with one of these companies.
DIY Debt Settlement
If you do decide to go it alone, then you’ll need to get your ducks in a row before you start contacting your creditors. First, make note of how much you owe each creditor and how much you are willing to settle for. Again, most settlement plans are for 40%-60% of the total amount that is owed, but if you are confident in your ability to negotiate, you may be able to settle for even less.
Be sure to take thorough notes during your conversations with your creditors so that you can remember what was said. And don’t send any money anywhere until you have a signed agreement in hand. Finally, be prepared to quickly send a lump-sum payment to your creditor. Agreements often come with a short window for payments. Although this may be difficult to accomplish, some creditors will accept a lesser amount if you can pay it all at once. You may have to pay a higher balance if you can only do a payment plan.
Debt management and budgeting are two of the most important aspects of personal finance. In most cases, debt settlement should only be considered as a last resort or at least the last possibility before declaring bankruptcy. While it is one way to get debt relief, creditors are not obligated to negotiate with you, and even successful debt settlement agreements have drawbacks like tax consequences. This strategy will almost certainly damage your credit score and will make it harder for you to get new credit.
If you’re struggling to repay your debts, consider other options, such as a debt management plan, consumer credit counseling, or even Chapter 7 bankruptcy before proceeding with this course of action.