Compare Debt Settlement Pros and Cons
The term debt settlement comes from the idea that the creditor agrees to “settle” your account, and generally includes the closing of the account. Is debt settlement ever a legitimate and viable option? Yes, but only under certain conditions, and it can cause potentially negative effects to your financial situation and credit score. Understanding debt settlement pros and cons can help you decide if this option is something you should be considering.
How Debt Settlement Works
Debt settlement companies generally offer to contact your creditors on your behalf, so they can negotiate a better payment plan or settle or reduce your debt. Often a percentage of the amount you’d save on the settled debt will be charged as a fee for their service.
The company may try to negotiate with your creditor for a lump-sum payment that’s less than the amount that you owe. While they’re negotiating, they may require you to make regular deposits into an account that’s under your control but is administered by an independent third-party. You use this account to save money toward that payment.
The debt settlement company may also advise you to stop paying your creditors until a debt settlement agreement is reached through negotiation.
Once the debt settlement company and your creditors reach an agreement — at a minimum, changing the terms of at least one of your debts — you must agree to the agreement and make at least one payment to the creditor or debt collector for the settled amount. At this point, the debt settlement company can begin charging you fees for its services.
Keep in mind that there is no guarantee the company will be able to reach a debt settlement agreement for all of your debts.
Considering the Pros
If a creditor being willing to accept a percentage of what you owe and cancelling the rest of the debt sounds too good to be true, it often is exactly that. Outside the debt settlement industry, debt settlement is viewed as risky business for consumers in part because it can be a playground for scam artists. In some cases, that life preserver tossed your way won’t keep your head above water.
But consumers reasonably considering debt settlement also recognize they have limited options. And the benefits for those people are worth consideration. Be sure that you fully vet any company you are considering using to ensure they are legitimate.
Get Relief from Unbearable Debt and Repay Your Debt Faster
Expediency isn’t always at the top of the list of benefits to other financial relief avenues, such as debt management plans and credit counseling programs. Debt settlement can help people with overwhelming debt pay less on the amount owed and, often, the process of settling debt is faster than other routes.
How fast? A legitimate debt settlement program could allow you to pay off your debt in two to four years. Other options — debt consolidation, bankruptcy, credit counseling repayment programs — typically take longer.
Most often consumers in need of debt settlement aren’t deciding between that route and repaying their entire debt over a longer period of time. The conventional way hasn’t worked for them. The choice frequently comes down to debt settlement versus bankruptcy,
One thing to keep in mind is that debt settlement, with whatever strings attached, has a negative impact your finances, though not as much as Chapter 7 or Chapter 13 filings. So, it can be a more palatable alternative to filing bankruptcy.
What’s the benefit of debt settlement to creditors? They might not spell it out, but debt settlement for creditors means they at least get some money. It is often an acknowledgment that they could receive even less money if someone files Chapter 13 bankruptcy and possibly nothing at all through Chapter 7 bankruptcy.
For you, it’s no small difference between debt settlement and bankruptcy. While debt settlement will stay on your credit report for seven years, bankruptcy filings can be a life-long companion.
A bankruptcy filing remains on your credit report for seven years (Chapter 13) or 10 years (Chapter 7) and it can follow you even longer since credit cards, loans and even some job applications ask if you’ve ever filed bankruptcy.
Your Debt Won’t Be Sent to Collections or Charged Off
Debt settlement can help people avoid their debt being sent to collections or being “charged off,” which means it has been sold to a debt collection agency.
Debt settlement won’t miraculously end your financial problems, in the short term or long term. But one clear benefit is that it will stop calls from debt collectors once an agreement is reached.
Lowering your debt amount and helping you avoid bankruptcy are monetary benefits, albeit benefits with inherent risks. Stopping calls from creditors and collection agencies is a less tangible but equally important benefit for some consumers feeling overwhelmed and harassed.
Avoid Being Sued for Your Debt
You may have a different opinion on what constitutes a worst-case scenario, but facing a lawsuit is certainly near the top of everybody’s list.
Debt settlement might help you avoid being sued for credit card debt and being involved in a long contentious proceeding.
Unsecured debt such as credit cards, store cards or unsecured loans can be settled. Secured debt such as mortgages and car loans cannot. The home will be foreclosed or the car will be repossessed. There is nothing any debt settlement company can do to avoid that.
Creditors do not have to agree to settle debt any unsecured debt or they may offer a settlement that you might not be able to afford. Since lawyers don’t come cheap for anyone, credit card companies often have clear incentive to settle a debt and avoid legal proceedings.
Disadvantages of Debt Settlement
The advantages of debt settlement might make it a compelling option for debt relief but consumers should consider the strings attached in making the best decisions to get out of debt.
Debt Settlement Fees
Many debt settlement providers charge high fees generally falling anywhere between $500-$3,000 but some can charge even more. These fees are not applied to your debt and they go straight into the agencies’ pockets.
Debt Settlement Impact on Credit Score
While not as devastating as a bankruptcy, debt settlement will have a negative impact on your credit score as the settlement may be reported by the creditor to each of the three leading credit bureaus. This will in turn affect your future loan terms, credit availability, employment opportunities, and more.
You will most often be asked to make payments to an account that will be used to pay your debts once a settlement is reached. The company can hold the funds in escrow for months or even years. In some cases, the provider tells you it needs the time to “negotiate” with your creditors, while little progress is made on your case. It simply holds your cash, which you could be using for better things. Worse, providers may refuse to return the money, if you’ve signed anything giving them rights to it (even if you didn’t realize you had). Be sure you read EVERYTHING before signing.
Debt Settlement Tax Implications
If a creditor agrees to settle your debt in exchange for a reduced payment, you may still be responsible for taxes on the reduced debt. Basically, if the settlement results in a debt reduction of $600 or more, the creditor is required to notify the IRS. For example, if you owe a creditor $10,000 and it agrees to settle with you for a one-time payment of $7,500, the reduced amount, $2,500 must be included as part of your taxable income.
Creditors Could Refuse to Negotiate Your Debt
That debt settlement company you’re paying to negotiate a lesser amount may not be able to reach an agreement. Debt settlement is at the discretion of each individual creditor. Some creditors outright refuse to deal with debt settlement companies.
You May End Up with More Debt Than You Started
Debt settlement companies recommend you stop payment on your debts while they negotiate with creditors. That negotiation is often not a streamlined process and can take quite some time.
It is always up to you if you want to follow the recommendation of the debt settlement company during the negotiation process. Stopping payment on a debt means you could face late fees and accruing interest. Additionally, just because a creditor agrees to lower the amount you owe doesn’t mean you’re free and clear on that particular debt. Forgiven debt could be considered taxable income on your federal taxes.
Debt Settlement Alternatives
Depending on your situation, you may have some leverage you can use to negotiate your own debt relief plan. Call your creditors directly and ask them if they will lower your interest rates and/or waive late or over-limit fees to reduce your balances. Creditors are becoming more and more willing to work with customers. There are also some alternative things you can try:
A reputable credit counseling service can help you find a solution that fits your personal financial situation. These nonprofit agencies offer free credit counseling sessions, which include a budget evaluation, online, via phone or face-to-face. They assess your total financial picture to make recommendations accordingly, and guide you towards a customized solution. A credit counseling service could help you pay off your debt through debt management, a bill consolidation program with lower monthly payments, reduced interest and a 3-5 year commitment.
Credit counseling is a viable option for thousands of consumers that can help avoid bankruptcies, wage garnering and court judgments. In fact, leading creditors have recently banded together to begin offering hardship plans that allow consumers to pay more affordable percentages of their total balances, which also includes lowering interest rates, so debts can be repaid within 3-5 years.
Alternative options, such as referrals to social service organizations, or legal assistance, may also be offered.
Credit Card Balance Transfer
One option if you have credit card debt is to transfer the balance to another card.
This strategy is usually employed to take advantage of an introductory 0% interest offers on a new card.
Is it that simple? Not always.
First, you must qualify for a credit card balance transfer, which usually means a credit score of 670 or better. Second, you need to determine whether you’ll pay more on the interest payments of your existing card than the fees you’d be charged to transfer a balance. Ideally, you’d try to pay the balance off on the new card before the promotional period expires to avoid interest.