Pros & Cons of Debt Settlement

There are pros and cons to most financial decisions. And debt settlement is no exception. Debt settlement helps you pay off old debt, but it can also hurt your credit score. You need a good credit score to get a credit card, auto loan, mortgage, and sometimes even a job. How are you supposed to get ahead if paying off your debt sets you further behind? In this article, we’ll take a closer look at the pros and cons of debt settlement, so you can decide what’s best for you.

What Is Debt Settlement?

Debt settlement is a tactic to settle a debt for less than the total amount owed. Most debt settlements are paid in a lump sum. Less commonly, your lender may agree to let you make payments. The settlement amount is usually determined through debt negotiations and will depend on the amount of debt you owe and how far behind you are on your debt payments. You can negotiate directly with a creditor and make a settlement offer, or you can use a debt settlement company to negotiate on your behalf.

Pros and Cons of DIY Debt Settlement vs. Hiring a Debt Settlement Company

Having someone negotiate with your creditors on your behalf may sound great, but it also has its drawbacks. For one, many debt settlement scammers prey on people who owe debt by charging excessive fees or outright committing fraud. One sign of fraud is a debt settlement company that asks you for money upfront. This is illegal. 

The Federal Trade Commission (FTC) takes legal action to stop these scammers, but they still exist. Before you start a conversation with a debt settlement company, be sure to check them out with the Better Business Bureau (BBB). You should also check to see if they have a history with the FTC, your state’s attorney general office, and the Consumer Financial Protection Bureau (CFPB). 

A reputable debt settlement company can offer you the benefit of experience. They’ll have industry insider knowledge and know who to call and how to negotiate terms that are likely to be accepted. Their negotiators may also have professional negotiating skills, which is a big advantage of hiring a debt settlement company.

But it’s important to remember that many creditors refuse to deal with debt settlement companies altogether. They only negotiate directly with borrowers. Though you may find this intimidating, negotiating for yourself will save you a lot of money. Though a debt settlement company can’t charge you fees upfront, it will charge you sometimes very high fees once the work has been complete. DIY debt settlement will help you save money and avoid scammers.

Advantages of Debt Settlement

Debt settlement works well for people who want to address unsecured debts. Common consumer debt like credit card debt and medical bills are eligible for debt settlement. But secured debts, like mortgages and auto loans, are not. Also, student loans are not usually eligible for settlement, though there are other ways to address them if you’re struggling to pay. Debt settlement is a faster way to resolve unsecured debts than filing bankruptcy or making a debt management plan. 

When working out a debt settlement, be sure to thoroughly investigate both the debt settlement company and your creditors. You want to make sure you are working with the creditor that owns the debt. Some debt settlement scammers will pretend to pay a creditor but keep the money, leaving you out the money and still owing a large debt. 

Getting Relief From Overwhelming Debts

Debt settlement is different from debt management. Successfully negotiating your debt and paying the settlement gets rid of your debt faster and at a lower cost than a typical repayment plan. Your account will be closed once the agreed-upon settlement amount is paid.

Paying Off Your Debts in Less Time

It will take less time to pay off your debt through debt settlement than with a traditional debt repayment plan. If you have the lump-sum payment and some negotiation skills, you could close the account within a few months. A debt management payment plan, on the other hand, could take 2-5 years. Bankruptcy could take anywhere from a few months to a few years, depending on your debts, assets, and the type of bankruptcy you file.

Avoiding Bankruptcy

If you want to avoid bankruptcy, debt settlement could be the option for you. Bankruptcy is an excellent way to get a fresh start if you have unmanageable debt and don’t see a way out, but there are consequences. Bankruptcy will more seriously impact your credit score than debt settlement. It may also be more challenging to get a loan or even a job in certain industries after filing bankruptcy. If you can settle a debt instead of filing bankruptcy, you’ll get your head above water faster.

Disadvantages of Debt Settlement

Debt settlement may be a better option than bankruptcy, but it’s still going to have some negative consequences and challenges. 

Your Creditors May Not Agree To Negotiate

One challenge is not all creditors will agree to a debt settlement. Some just flat-out refuse. In that case, you’ll have to see whether you can enter into a repayment plan and explore other debt-relief options. You may qualify for a debt consolidation loan. You might be able to take out a new loan to pay off your older loans. Some credit card companies offer other types of debt relief programs and debt repayment plans to members of the military and people going through hardships.

Additional Late Fees

Your debt can grow while you’re working on debt settlement. If you only missed one or two payments, your lender is unlikely to offer a debt settlement. Creditors have no real motivation to charge off your debt if you’re still making timely payments, so many people stop making payments entirely to get them to negotiate. But while you aren’t making payments, your debt will still accumulate interest and you’ll also be subject to late fees, which means your debt will grow. Managing more debt while trying to pay off old debt is no easy feat!

A July 2020 quarterly report from the Consumer Financial Protection Bureau found that most debt settlements occur after an account is charged off, sent to collections, or is more than 150 days past due. The study also found that the average amount of time between charge-off status and debt settlement was 12 months. The downside of this is that while you’re working on your debt settlement plan, the increased debt, late fees, and missed payments will put a big dent in your credit score.

Impact on Your Credit Score

Debt settlement impacts your credit score in a few ways. Since you have to be behind on your debt to get a debt settlement, those late payments will contribute to a drop in your credit score. Also, accounts that are settled are then closed. This affects two factors of your credit score: the length of your open accounts and the amount of credit you have available (part of your credit utilization ratio). 

Also, a settled debt is often reported to the credit bureaus as “partial payment.” This hurts your credit score as well. You might be able to negotiate this with the creditor in addition to the amount of the debt you’re negotiating. Ask the creditor to report the debt as “paid in full.” No matter how the settlement shows up on your credit report, it will stay there for seven years. During those seven years, you can take the initiative to start rebuilding your credit so the negative aspects of the debt settlement will fade away.

Tax Consequences

Debt settlement also comes with potential tax consequences. The money you save in your debt settlement is called canceled debt. The IRS considers this taxable income. Generally, if you save $600 or more you’ll have to declare your savings as income when you file your taxes. There’s no hiding this because the IRS will have a record of the debt settlement. 

Alternative Debt Management and Relief Solutions

If you can’t get a large lump sum to pay a debt settlement or if your credit card company refuses to negotiate a debt settlement, there are other debt relief and management options. Contact your creditors and ask them what hardship programs are available for people having financial difficulties. There may be a program for you, particularly if you are a member of the military. You can also consider credit counseling and even filing for bankruptcy.

Credit Counseling

Talking to a credit counselor can help you work through your options. There are many accredited nonprofit credit counseling agencies, and the first visit is free. You could even have a phone visit. The counselor will go over your current debt, credit, income, and financial status to help you figure out what plan is best for you. They can even work with your creditors to help develop a debt management plan (DMP). 

A debt management plan is a form of debt consolidation. With a DMP, you make one big monthly payment to the credit counseling agency instead of several smaller monthly payments to your creditors. This can help you avoid missing payments or making late payments, which hurt your credit score. Your monthly payment should be more manageable, and you may even be able to get lower interest rates. 

Filing for Bankruptcy

Bankruptcy is often seen as a last resort, but it has many benefits. Bankruptcy can help you wipe out all of your unsecured debt at once, and you could keep your car and house if you can enter into a new repayment plan. A Chapter 7 bankruptcy works well for people that have no assets but have lots of unsecured debt, such as medical bills, credit card debt, and personal loans. If you’re a renter with lots of debt and low income, a Chapter 7 might work for you. To qualify for a Chapter 7 bankruptcy, you must be within a certain income limit. Many Chapter 7 bankruptcies are completed in less than a year.

A Chapter 13 bankruptcy works best for people that have a car, house, and other assets they want to keep. A Chapter 13 bankruptcy allows filers to make repayment plans, but luxury items can still be sold to pay off unsecured debt. If there are no assets to pay off unsecured debts, then the debt can be discharged. A discharged bankruptcy debt means the account is closed with a $0.00 balance and no further collection activity is allowed. When you consider that this applies to all of your discharged creditors, that is a big pro for bankruptcy. You’ll be on firm footing to reinvent your financial future.

The big disadvantage to either type of bankruptcy is that your credit score will drop. A Chapter 7 bankruptcy will be on your report for ten years, and a Chapter 13 bankruptcy will be on your report for seven years. That sounds like a long time, but the negative effect of filing bankruptcy isn’t permanent and there are things you can do to rebuild your credit.

Let’s Summarize...

Debt settlement has several pros and cons. It helps clear up your unsecured debts and saves you money, but it also has a negative impact on your credit score. It’s a faster way to get debt relief than a debt management plan and it won’t negatively affect your credit score as much as a bankruptcy, but some creditors won’t be open to negotiating your debts.

There is more to learn about debt settlement. If you’d like to learn how debt settlement affects your credit score, take a moment to read “Debt Settlement: How It Affects Your Credit Score” to learn whether debt settlement is the best method to help you reach your financial goals.