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How Debt Settlement Works And When You Should Consider It

Debt settlement is an agreement to pay less than the amount owed to your creditors, reducing your overall debt. With American consumer debt having reached $5.1 trillion in August 2024. According to the Federal Reserve many people are considering this option. Whether you have mounting credit card bills, unexpected medical expenses, or unmanageable personal loans, you need to know about debt settlement before you make a decision.

Before exploring debt settlement, you should know that though it lowers your debt, it drastically affects your credit score and taxes.

This article will provide you with the ability to make an informed decision on whether debt settlement is right for your financial situation.

What is Debt Settlement and How Does it Work?

Debt settlement is a negotiation with creditors to pay a percentage of what you owe as full payment. Instead of making minimum payments for years or filing bankruptcy, this can help reduce your overall debt.

For example, A $15,000 credit card debt might settle for $7,500. But you need to understand the whole process before you decide.

The debt settlement process works in 3 steps:

  1. By stopping payments to creditors, you show financial hardship and it usually takes 4-6 months before creditors consider settlement options.
  2. During this time, you’ll start saving in a dedicated settlement account as your negotiation fund. Settlement companies usually require monthly deposits based on your total debt amount.
  3. Once you’ve saved enough (usually 40-60% of your debt), negotiations begin. Creditors might accept your first offer, suggest a different amount, or decline to settle.

Costs & Important Considerations

Settlement Company Fees:

  • Companies typically charge 15-25% of your original debt amount
  • Fees are only charged after a successful settlement
  • Get all fee structures in writing before enrolling

Settlement Range Examples:

  • Settlement amounts vary significantly by creditor and circumstances
  • Typically range from 30-70% of original debt
  • Each creditor has different settlement policies
  • No guaranteed settlement percentage

Additional Financial Impacts:

  • Expect tax bills on forgiven debt over $600 (IRS considers it income)
  • Your credit score will likely decrease significantly
  • Program duration typically 2-4 years
  • Monthly deposits are required for settlement funds

Eligible Debt Types:

  • Best for: Credit cards, medical bills, personal loans
  • Not available for: Federal student loans, mortgages, car loans

Key Factors Affecting Settlement:

  • Age of debt
  • Type of debt
  • Creditor policies
  • Your financial situation
  • Lump sum vs. installment offers

More Questions About Debt Settlement? Read Our FAQ

Should You Consider Debt Settlement?

Debt settlement makes sense in certain situations but it’s not just about how much you owe. Your overall financial picture is what determines if this is for you.

Debt settlement might be for you if:

  • You can’t make minimum payments.
  • Your unsecured debt is 50% or more of your income.
  • You’re behind on credit cards, medical bills or personal loans.
  • Your total debt (excluding mortgage) is over $10,000.
  • You can put aside money each month for settlements.
  • You take a temporary hit on your credit score.

But consider other options if:

  • You’re making minimum payments on time.
  • Your financial struggle is temporary.
  • Most of your debt comes from student loans, mortgages or car loans.
  • You have assets to sell to pay debt.
  • Your debt is under $10,000.
  • You need to keep your credit score high.

Consider your budget. For example, with $20,000 in debt you’ll need to save $400-500 a month for settlements. Calculate your debt-to-income ratio: divide monthly debt payments by monthly take-home pay. If it’s over 50% (like $2,200 in debt payments on $4,000 income), debt settlement might help your situation.

What are Debt Settlement Programs?

A debt settlement program is a legal way to avoid bankruptcy and reduce your debt. Here’s how they work.

Before you enroll, we review your financial situation to see if the program is right for you. Then the process goes like this:

  1. You’ll open an FDIC-insured account in your name which will be the foundation for your settlement funds.
  2. Instead of paying creditors directly, you’ll make monthly deposits into this settlement account based on your total debt and what you can afford.
  3. Once you have enough funds, we start negotiating with creditors. Each debt is settled individually using your saved money.
  4. The whole process takes 24-48 months during which time we’ll manage creditor communications and negotiations for you.

Benefits:

  • Debt reduction
  • Stop collection calls
  • Avoid bankruptcy
  • Consolidate payments
  • Eliminate late fees and penalties

Challenges:

  • Initial credit score decrease
  • Tax on forgiven debt over $600
  • There is no guarantee creditors will settle
  • Collection calls may continue
  • Creditors may sue you

Process of Do-It-Your-Own Debt Settlement

Settling your own debt can save you money on fees and potentially get your debts paid off faster. What you need to know about doing it yourself.

  1. Before you start your DIY journey, gather info on each debt: how much you owe, who to and how far behind you are. This will help you create a realistic plan for negotiations.
  2. Check your debt eligibility first. Has the statute of limitations expired on your debts? If so collectors can’t sue you for payment. Also, make sure collectors actually own the debt they’re trying to collect through a debt validation letter.
  3. Create a settlement fund before you start negotiating. Set aside money in a separate savings account. Most creditors want lump sums so aim to save 40-50% of each debt before making offers.
  4. Start negotiating when you have funds. Contact creditors with a clear and professional approach. Start with a lower offer than your maximum, as creditors will counteroffer. Get any agreements in writing before sending payment.

Be factual and businesslike in your negotiations. Explain your hardship briefly, make your offer clear and always follow up on verbal agreements with written confirmation. Never send money until you have a signed settlement agreement.

Want to learn more? Read debt settlement negotiation and credit score impacts at NFCC.org.

DIY settlement red flags:

  • Don’t give creditors access to your bank account.
  • Don’t believe anything unless it’s in writing.
  • Keep records of all conversations.
  • Never send money without written agreements.
  • Know the tax implications of settled debt.

Working with Debt Settlement Companies

If settling debt yourself feels too much, working with a debt settlement company might be the next move. Let’s look into what they offer and how to choose one.

Professional debt settlement companies negotiate with your creditors while providing structured support throughout your debt resolution process. They handle all creditor communications and manage the whole process from start to finish.

  1. Most companies start by reviewing your debts and creating a payment plan based on what you can pay. They’ll set up a dedicated FDIC insured account for your settlement funds and negotiate with creditors once you’ve saved up.
  2. You’ll deposit money into your settlement account each month instead of paying creditors directly. This money is your settlement fund which the company will use to negotiate with creditors on your behalf.
  3. Companies work with all your unsecured creditors at the same time and settle each debt as funds become available.
Pros of Settlement CompaniesCons of Settlement Companies
1. Professional negotiation experience1. Fees 15-25% of settled debt
2. Handle all creditor communications2. Less control over negotiations
3. Know the settlement laws3. Program length 24-48 months
4. Structured program management4. Impact on credit score
5. One point of contact5. No guarantee of settlement
6. Established creditor relationships6. Monthly fees for account maintenance
7. Help with documentation 
8. Know debt settlement laws 
9. Less legal hassles 

How to Choose a Real Debt Settlement Company

Choosing a debt settlement company requires research to avoid scams and make sure you’re working with a legitimate company. Before signing anything, follow these steps to verify the company’s legitimacy and protect your financial interests.

Check Company Reputation

Before choosing a debt settlement company check their BBB rating and review the company history. Look for companies with high ratings and good customer reviews. See how they handle complaints and their responses to customer concerns. A good track record of resolving issues means they’re reliable.

Verify Legal Requirements

Legit companies have state licenses and registration. Ask for their registration numbers and check them through your state’s consumer protection office. They should provide documentation and encourage you to verify their credentials through official channels.

Evaluate Performance History

Real companies share data on their settlement results. Ask about average settlement rates, program completion times and client success stories. Be cautious of companies making unrealistic promises or guaranteeing specific results. Good companies offer realistic expectations.

Know All Fees

Review the entire fee structure before you enroll. Companies should provide written documentation of all fees including when and how you will pay fees. Don’t work with companies that won’t discuss fees or use vague language about their pricing. All fees should be spelled out in your contract.

Protect Your Money

Make sure any dedicated settlement account is FDIC-insured and in your name. You should have control of your funds and know exactly how they will be managed. Get written details about account security, fund management and your access rights.

*Don’t sign up with a company that’s pushing you to enroll or won’t give you written details of their services, fees and policies. Research everything they tell you.

Red Flags When Choosing a Debt Settlement Company

It is highly difficult to find a debt settlement company since most scammers are good at looking legitimate.

Learn these red flags to protect yourself from debt settlement scams and financial harm.

Look for Upfront Fees

Never pay companies that want payment before they settle your debt. It is illegal. Legit companies only charge fees after they settle your debt. Be extra cautious of those who want payment during the initial consult or for basic info.

Ask Unanswerable Questions

Never sign up with companies that promise fixed amounts in settlement or even promise any settlement for every debt. Every creditor settlement is unique, so no company can guarantee fixed results. Claims of clearing accurate, legitimate negative credit items or promising fixed percentages on settlement are usually false claims.

Find Pressure Tactics

Legitimate companies give you time to review their services without any pressure. Be very cautious of high-pressure sales or artificial deadlines when signing up. A good company lets you make an informed decision and provides clear documentation of their process.

Observe Communication Issues

Good companies will give you clear, written explanations of their process, timelines, and fees. Any company that is vague does not provide basic information, such as a physical address or license, or evades direct questions is a red flag.

Beware of Government Claims

The government does not support debt settlement companies. Be very wary of anyone claiming special government connections or hyping "new government programs" for debt relief. It probably is a scam.

Alternatives to Debt Settlement

Before you commit to debt settlement, consider these other debt relief options that might be a better fit for you.

Debt Management Programs

A debt management program through a nonprofit credit counseling agency helps you pay off your debt in full while potentially reducing interest rates and fees. You make one monthly payment to the agency and they pay your creditors. This has less of an impact on your credit score than debt settlement.

Debt Consolidation

Taking out a new loan to pay off multiple debts can simplify your payments and potentially lower your interest rate. This works best if you have good credit and steady income. You might use a personal loan or balance transfer credit card to consolidate high interest debts into one payment.

Credit Counseling

Nonprofit credit counseling agencies offer free or low cost advice about your debt options. They review your finances, help you create a budget and suggest debt relief strategies. Do this before any debt relief program.

Bankruptcy

Though serious, bankruptcy may be an option if you can’t pay your debts through other means. Chapter 7 eliminates most unsecured debts, and Chapter 13 creates a payment plan. Talk to a bankruptcy attorney to see if this is an option for you.

Self-Payment Plan Create your own debt repayment plan by:

  1. Talking to creditors for lower interest rates
  2. Cutting expenses and paying extra towards debt
  3. Using debt snowball or avalanche payment methods
  4. Selling items or taking on extra work for debt payments

It depends on:

  • Total debt
  • Types of debt
  • Income stability
  • Credit score
  • Long term goals

Types of Debt You Can and Can't Settle

Knowing what debt can be settled helps you make a realistic plan for debt relief. Let’s look at what you can and can’t settle.

Debt You Can SettleDebt You Can’t Settle
Credit cardsFederal student loans
Department store cardsRecent taxes
Old utility billsCourt-ordered alimony
Medical billsChild support
Personal loansMost government debt
Private student loansCurrent utility bills
Business debtMortgage loans
Collection accountsCar loans
Old checking account feesHome equity loans
Cell phone billsRecent tax debt

Consider these points:

  1. Generally, credit cards and medical bills are the best settlement opportunities because creditors usually agree to accept reduced payments for delinquent accounts.
  2. Such student loans cannot be defaulted in a traditional manner, but sometimes a private student loan might settle with the lender.
  3. Secured debts such as mortgages and car loans cannot be settled because they are secured by assets while unsecured debts do offer better settlement chances.
  4. Collection accounts usually settle for less because agencies buy such debts at deep discounts; however, verify ownership of the debt before negotiating.

The Bottom Line

Debt settlement can help if you are drowning in debt but it’s not for everyone. Your success with any debt relief option depends on making an informed decision and knowing all the details.

Before committing to debt settlement or any other debt relief program, take your time to learn how it works, how it affects your credit score and what the tax implications include. If required, talk to a nonprofit credit counselor to get unbiased advice on your options. Always get everything in writing before moving forward with any program.

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