If you’re overwhelmed by debt, debt settlement may offer a solution. It involves negotiating with your creditors to pay off your debt for less than what you owe. In some cases, a creditor will accept just 50% of your balance.
A successful debt settlement has the potential to save you money and get you out of debt, but it comes with serious trade-offs, including potential fees, damage to your credit, and tax liabilities. There’s also no guarantee that your lender will agree to settle your debt.
It’s important to understand these pros and cons to determine whether debt settlement is a viable path for you.
How the debt settlement process works
While you can pursue debt settlement on your own, there are companies that offer debt settlement services and negotiate directly with the lender on your behalf. Here are the steps you’ll typically take to settle a debt:
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Step 1: Stop paying. A debt settlement company will usually tell you to stop paying your loans. Stopping payments will give you leverage to negotiate, since your creditors may prefer partial repayment to no repayment at all.
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Step 2: Save funds in a dedicated account. Instead of making payments on your debts, you’ll deposit funds into a separate savings account. If the settlement is successful, you’ll use those funds to pay off the negotiated debts in a lump sum. A settlement company must tell you how much you need to save upfront before it will begin negotiations.
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Step 3: Negotiate with the lender. Once you have enough in savings, you or the debt settlement company will negotiate with the lender and make a settlement offer. The creditor may agree to close the debt for a smaller amount.
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Step 4: Pay off the debt. If the settlement is successful, you’ll send off the agreed payment. Make sure to get written confirmation that the debt has been settled and your account is closed.
Types of debts that can be settled
Debt settlement is generally an option for unsecured debts that aren’t backed by collateral. These include credit cards, personal loans, private student loans, and medical bills.
Secured debts, on the other hand, may not be possible to settle. These include mortgages (backed by your home) and auto loans (backed by your car).
Settling federal student loans may be an option in select cases, but first explore alternative forms of relief like income-driven repayment, deferment, forbearance, and forgiveness programs.
Pros and cons of debt settlement
Debt settlement may offer relief from debt, but it comes with significant downsides too. Consider both the pros and cons of this form of debt relief.
Pros
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It can reduce your balance: If you’re able to successfully settle a debt, you can pay it off for considerably less than what you owe.
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You can end collector calls: By closing out your debts, you’ll no longer have to deal with communications from collection agencies.
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You could avoid bankruptcy: Debt settlement can be an alternative to bankruptcy, which can be even more damaging to your credit.
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A company can negotiate on your behalf: If you work with a debt settlement company, professionals can handle negotiations with your creditors on your behalf.
Cons
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It will damage your credit: When you stop paying your debts, those missed payments are reported to the credit bureaus, which can hurt your credit score. A low credit score and delinquent accounts can make it hard to get approved for new credit in the future.
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You could face a tax bill: If your creditor agrees to settle your debt, the amount that’s canceled is treated as taxable income if it’s more than $600. So if you settle a $10,000 debt for $7,000, you’ll owe taxes on the $3,000 that was forgiven.
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Settlement companies may charge high fees: Debt settlement companies often charge you a percentage of your debt amount, sometimes as high as 25%. You may also have to pay a monthly fee for the dedicated savings account.
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There’s no guarantee of success: Creditors don’t have to approve a debt settlement or work with a debt settlement company. If they refuse your offer, you’ll face an even higher balance due to late fees and interest charges, as well as damaged credit.
DIY debt settlement vs. debt settlement companies
You can attempt to settle debts on your own or hire a debt settlement company to help you navigate the process. Handling negotiations on your own could make sense if you have a relatively straightforward situation and are comfortable negotiating with your creditors.
You’ll need to save enough to offer a lump-sum payment, and it may help if you can demonstrate that you’re facing financial hardship. You’ll avoid the fees that settlement companies charge, but you’ll also have to manage the entire process on your own.
If you’re feeling overwhelmed with multiple debts, hiring a debt settlement company may be preferable. Professionals can take some of the work off your plate by negotiating with creditors on your behalf.
They’ll guide you through the process step by step, which usually involves:
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Enrolling your qualifying debts
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Making monthly deposits into a dedicated savings account
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Waiting while the company negotiates your settlement
The downside of hiring a debt settlement company is the potential for high fees, often a significant percentage of the debt you enroll. You may also have to pay a separate fee for your dedicated savings account.
It’s important to understand the fees before you enroll. If the company isn’t upfront about costs or demands payment before a debt is negotiated, you could be dealing with a debt settlement scam. Beware of any companies that lack transparency, use high-pressure sales tactics, or promise specific results.
No debt settlement company can guarantee success, since the final decision is up to your creditor.
Effects of debt settlement on your credit
Debt settlement has a negative impact on your credit, since it typically requires you to stop paying back your debts for a period of time. Your payment history accounts for 35% of your credit score, so missing payments can cause significant damage that lasts for years.
If your debt is settled, the account will also appear as “settled for less than full amount” or similar on your credit report. This information can be a red flag for future lenders, who may be hesitant to extend new credit to consumers with a history of settled debt.
Late payments and settled debts typically stay on your credit report for up to seven years, though the negative impact can lessen over time. If you do settle your debts, there are steps you can take to rebuild your credit, such as:
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Making on-time payments on any future loans and credit cards
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Keeping your credit utilization on your credit cards below 30%
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Using a credit-building tool, such as a secured credit card or credit-builder loan
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Becoming an authorized user on someone else’s credit card
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Using a service that reports your rent and utility payments to the credit bureaus
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Avoid opening lots of new credit accounts in a short period of time
Your credit score is based on multiple factors, but payment history and credit utilization are two of the most important. Paying your bills on time and keeping your credit utilization low can help you slowly but surely rebuild your credit over time.
