What Is Debt Settlement And Is It Right For You?

Debt settlement may be the best solution if you’ve been struggling to pay your bills and find it difficult to even afford your basic necessities. While you can negotiate with your creditors on your own, there are debt settlement companies that claim they can help you. Before taking this route, it’s key to have a clear understanding of what is and isn’t considered debt settlement.

What Is Debt Settlement?

Debt settlement is a process during which you negotiate with your creditors to either eliminate your debt or pay less than what you currently owe. The aim is to settle the debt so that you’re paying less overall, giving you more breathing room in your finances. Loan settlements typically only work when the borrower can prove they no longer can afford to pay back the original debt. The lender would rather receive some money back than none at all, so they may be willing to work with the borrower to arrive at a settlement amount.

Which Debts Can You Settle?

There are several types of debts that are typically eligible for debt settlement, including:

• Personal loans
• Credit cards
• Medical bills

However, not all lenders are willing to settle debts. Plus there are certain types of debt that typically aren’t eligible for settlement. Some of these include secured debts, such as car loans and mortgages, as well as federal student loans.

How Does Debt Settlement Work?

There are two main ways you can settle your debt: by yourself or through a debt settlement company. In either case, you or the debt settlement company working on your behalf will work with your creditors to see whether they’re willing to settle the debt, and by how much. Depending on the lender, they may be willing to lower the overall amount you owe, your interest rate, or some other type of agreement. Once everyone agrees to the terms of the debt settlement, the creditors will work with you to establish a start date for the new terms.

Reaching An Agreement On Your Own

Yes, you can reach out to your creditors and lenders yourself. Before doing so, it’s helpful to understand your rights and responsibilities and how you can increase your chances of having your debt settled.

Because you are speaking with your creditors yourself, you will have to do more upfront legwork. This includes understanding exactly what you owe to each creditor, your interest rate, how far behind you are, and what your current financial situation is. That way, you can use this information to negotiate an amount you feel like you can reasonably pay back.

Since you are taking on all the responsibilities to negotiate and settle the debt, it can take a lot of time and effort. However, the main advantages are that you know exactly what is happening during every stage of the negotiation process, and you’re avoiding paying fees to a debt settlement company.

Working With A Debt Settlement Company

If you feel more comfortable working with a professional and don’t have much time on your hands, a debt settlement company might be the right option for you. These third-party companies will negotiate and settle applicable debts on your behalf. During the negotiation process, the debt settlement company may have you stop paying your loans to the creditor, or they may have you put your payments into a savings account. Once an agreement has been settled, you would pay the debt settlement company who will then in turn pay your creditors until you are debt free.

Depending on the debt settlement company and your debts, it can take several months to several years to reach an agreement with your creditors, if one is reached at all. You will also have to pay a fee, which could be either a flat rate, monthly charges, or a percentage of the debt you were able to have removed. For instance, if the company was able to knock off $35,000 of your debts and charges a 15% fee, then you’ll have to pay $5,250. It’s up to you to determine whether it’s worth paying that to have a company potentially lower the amount you owe.

Keep in mind that while there are legitimate debt settlement companies, there are also many scammers out there. That’s why it’s important to do your research before working with a company. Watch out for red flags like guarantees that your debt will be settled or by a certain amount — a settlement company can’t guarantee how much they can win for you in your unique situation. And if they aren’t transparent about their fees, run the other way. Consider looking up information about the company, such as any reviews from the Better Business Bureau or Consumer Financial Protection Bureau.

The Pros And Cons Of Debt Settlement

Though debt settlement can be a great solution to help you manage your debts better, there are also some downsides to this method.

The Pros Of Settling Your Debts

Some of the benefits of loan settlements include lowering the amount you owe and avoiding financial consequences such as your loan going to collections or having to declare bankruptcy.

You May Be Able To Avoid Bankruptcy

If you find that your debt is too much to handle and you’re constantly behind on bills, then debt settlement can offer some much-needed relief. That way, you can give yourself some breathing room and avoid having to declare bankruptcy, which has a larger impact on your finances.

You May Reduce What You Owe

Debt settlement can help you decrease the amount you owe creditors, allowing you more wiggle room in your budget to direct towards other aspects of your financial life, such as having some savings in the bank and paying bills on time.

You May Avoid Collections

If you negotiate with your creditors hoping to reach a settlement, it could mean avoiding your loans going to collections (as long as you’re still attempting to make on-time payments). Since you’re acting in good faith to try and pay back your loans, not having your debts go into collections could mean that collection agencies won’t pester you.

The Cons Of Settling Your Debts

Though the potential of paying less on your debts sounds appealing, there can be some significant risks to debt settlement.

Your Credit Score May Take A Hit

Whether or not you're able to successfully settle your debts, your credit score could be negatively impacted. If an account on your history report indicates that you settled the debt, this mark may stay on your report for 7 years, which could impact your credit score. Plus, a debt settlement company may ask you to stop paying on your debts as it's helping you negotiate with your creditors — many lenders don’t tend to negotiate with borrowers who are making on-time payments. If so, you risk having late or missed payments on your credit history, further damaging your credit score. Payment history is one of the largest factors making up your score.

You May Have To Pay Fees

Debt settlement companies charge fees for their services; these can add up depending on how many debts you want to settle. Though the fees may seem much less compared to the amount of debt you’ll have forgiven, it may still be hard to afford them. Plus, there are no guarantees that the company will be successful in its negotiations, meaning you could still be on the hook for fees and still owe the same amount of debt.

What’s more, your lenders may charge late or nonpayment fees as you’re waiting to settle your debt. So, you could end up paying more than your original debts.

You May Not Be Able To Negotiate With Every Creditor

Creditors aren’t required to settle debts with their borrowers, even if they’re not able to pay them back. Whether you’re negotiating with creditors yourself or through a debt settlement company, you won’t be able to negotiate with all creditors or types of loans.

Your Settlement Will Take Time

It can take months or even years to be able to fully settle your debts, even if negotiations go well. In the meantime, you may still have to pay your minimum monthly payments. Or, if you’re not, you could be racking hundreds, if not thousands, of dollars in fees and late payments.

You Could Pay More Taxes

Yes, you can pay less than what you owe, but any forgiven debt counts as taxable in the eyes of the IRS. For example, if your creditors forgave $5,000 in debt, the IRS sees that as $5,000 worth of taxable income. In this instance, you will need to pay taxes on this amount.

How To Settle Your Debts

If you decide to attempt to settle your debts, consider the following steps and best practices to give yourself the best chance.

Start Early

Creditors are often more receptive to settlement when borrowers reach out early on. Consider reaching out to creditors as soon as you start feeling the strain in your debt payments and budget or want to explore debt settlement options. At this stage, it is a good idea to look at exactly what you owe and your overall financial situation to determine if it’s true you really can’t pay back what you owe.

Document Everything

In order to be able to negotiate well, you will need to present your case clearly. This means providing ample documentation proving that your financial situation is dire, and that debt settlement is the best solution for all involved. Documentation can include your other bills — like utilities, child care and transportation— current household income, and other debt obligations. It’s also helpful to document clearly what you can afford to pay back to so you have an idea of the settlement amount you want before any negotiations begin.

Negotiate The Settlement

Yes, it’s possible to negotiate the terms of your debt settlement, whether it’s having a certain amount forgiven, or having a lower interest rate. It’s also helpful to be open to what the creditor says, as they may have other suggestions that could work for you. Make sure whatever terms you settle on, they’re helpful to your financial situation, and you can reasonably afford them.

Alternatives To Debt Settlement

If you’re not comfortable with the risks that come with debt settlement, consider the following alternatives to help you manage your debt.

Debt Consolidation

Debt consolidation is the process of combining all your loans and rolling them into a singular debt. You would take out a debt consolidation loan and use the funds to pay off all your existing loans, leaving you with one loan payment. It can help to simplify your payments, and depending on your financial situation, your new loan may come with a lower interest rate. Keep in mind that you may not be able to consolidate all your loans, and there is no a guarantee that you’ll qualify for a lower interest rate.

Debt Management

Debt management entails you working with a professional or nonprofit counseling agency to come up with a plan that fits with your financial situation to pay off your debt. Though you'll still owe your creditors the same amount, you may be able to negotiate a better payment plan that works for you. It could also include restructuring your budget so you can better afford your debt payments.

Nonprofit credit counseling agents typically don't charge a fee — if there is one, it's usually lower than what debt settlement companies would charge. Make sure the company you want to work with is legitimate. Consider working with accredited agencies such as ones from the Financial Counseling Association of America or the National Foundation for Credit Counseling.

Bankruptcy

Filing bankruptcy should be considered a last resort. There are two types of bankruptcy you can file, and which type you choose will depend on your financial situation and whether you want to hold onto certain assets. It’s a good idea to work with an attorney to understand what you may be getting into. You will also have to face some negative consequences, such as significant setbacks to your credit score.

The Bottom Line

Debt settlement is an option you can pursue to give you some breathing room. However, it comes with significant risks and there are no guarantees it'll help you get back on track with your debt payments. Consider taking advantage of free resources such as the Rocket Money℠ app so you can see where your money is going, and get a handle on your spending and debts.