Debt Settlement: What are the Pros and Cons?

According to CNBC.com, the struggling economy, coupled with the highest inflation rates since early 1980, had credit card balances climb to 15% higher than the year before. This is the most significant annual jump in more than 20 years.

If you are one of those Americans struggling to keep up with the payments, debt settlement may solve your problems. But it’s important to know the pros and cons. Let’s take a look.

Key Points

You’ll be out of debt in two to four years
You won’t have to pay any upfront fees
Most unsecured debts can be settled
Your credit score will take a hit at first but will rebound

Advantages of Debt Settlement

Debt settlement offers a few key advantages that may make it better than other debt-relief options.

Get Relatively Quick Relief

With legitimate debt settlement programs, you can pay off your unsecured debts in two to four years. Still, most debt settlement companies will ask you to stop making monthly payments immediately.

No Upfront Fees

The average cost of debt settlement ranges from 15% to 27% of your total debts enrolled in a settlement program. That sounds high. But you don’t pay any money at all up front. The fee is tacked on to each settlement, and you don’t pay for the service until you approve each settlement agreement.

And when you factor in that settlements can range between 30% to 50% of the total you currently owe, you will still end paying less than the full total you owe, even after fees.

According to statistics, the average debt settlement customer will get out of debt by repaying 80% of what they owe, and the fees are included in this total.

Repay Your Debt Faster

Though the amount of time will depend on the total debt settled, it will usually be faster than many other options.

Debt settlement may repay your debt faster than debt consolidation loans, bankruptcy, or a nonprofit credit counseling agency, which will set up payment plans called Debt Management Plans.

You Can Settle Most Unsecured Debts

Debt settlement can help you deal with many types of debt, including medical bills, private student loans, and credit card bills. Debt settlement plans cannot settle secured debts like home loans and auto loans.

READ MORE: Debt settlement qualifications

You Can Avoid Bankruptcy

Even though your credit score will take a hit with debt settlement, it will be a slight reduction than if you file for bankruptcy, which will stay on your credit report for seven to 10 years. Bankruptcy should usually only be considered as a last resort.

Creditors prefer debt settlement. If you file Chapter 13 bankruptcy, they will likely get even less money than they get through debt settlement, and if you file Chapter 7 bankruptcy, they could end up with nothing.

It’s also important to note that filing for bankruptcy is not free. You will have to pay some upfront costs, particularly if you need to hire a bankruptcy attorney.

Debt Collector Calls Will Stop

Debt settlement will not miraculously fix your financial situation. But it will stop annoying collection calls from debt collectors once you reach an agreement.

Ceasing the harassing calls is a significant benefit if you feel harassed or overwhelmed. However, if you’re feeling harassed, remember that the FTC offers protections through the Fair Debt Collection Practices Act.

No Charge-Offs to Drag Down Your Credit Score

Charge-offs appear on your credit report when a creditor gives up hope that you’ll repay your debt and closes your account. However, that doesn’t mean a borrower is no longer obligated to pay. A charge-off will occur only after a creditor tries and fails to get you to pay the debt. This will cause serious damage to your credit score and your ability to borrow money in the future.

You May Be Able to Avoid a Lawsuit

Debt settlement might help keep you out of court due to unpaid credit card debt. Court appearances can be time-consuming and expensive if you have to take time off of work to appear. And though you won’t go to jail for unpaid credit card debt, you could be jailed for ignoring a court order or have to deal with wage garnishment.

Cons of Debt Settlement

There are also a few drawbacks. Some strings attached may not make it the best debt relief option for everyone.

Expensive Fees

Debt settlement companies can charge anywhere from $500 to $3,000 or more, but this money is not applied to your debts. And because you’re repaying less than the full amount you owe, you’re still saving money.

READ MORE: Debt settlement fees

Your Credit Score Will Go Down

Debt settlement will harm your credit score, though it won’t be as bad as if you file for bankruptcy. A poor credit score will affect future loan terms, interest rates, credit availability, employment opportunities, and more. People with higher credit scores will pay lower interest rates when they borrow. On the other hand, if your debt problems are already severe, you probably don’t have excellent credit to begin with.

READ MORE: How to get a free credit score

The Company May Hold Your Funds

Watch out for providers that require you to pay a large upfront lump-sum payment for “debt repayment” that they hold in escrow. Sometimes shady settlement companies will hang onto that money for years while making little progress on your debts. In some cases, they may even trick you into signing away rights to that money, then refuse to repay it. If a company requests to hold funds on your behalf, check reviews through the Better Business Bureau or other reputable sites to ensure that past customers haven’t been scammed. Although escrow accounts are common practice, it’s important to do your due diligence before enrolling with any debt settlement company.

There are Tax Consequences

If your settlement results in a debt reduction of $600 or more, the creditor must notify the IRS, and the accommodation will be included as part of your taxable income. For example, if you owe a credit card company $25,000 and the company agrees to a settlement of $10,000, $15,000 (the total of the forgiven debt) must be included as part of your taxable income. However, if you can prove insolvency, you won’t have to pay.

There’s No Guarantee Your Creditors will be Willing to Settle

Despite what a debt settlement company might tell you, creditors are not obligated to negotiate. Your debt settlement service may not be able to persuade your credit card company to accept a settlement offer, despite the fee you’ve paid to the company.

There Are a Lot of Debt Settlement Scams

Scammers target consumers by falsely promising to negotiate with creditors to reduce the amount they owe. They often make big promises, charge a hefty upfront fee, and still fail to get results. Vet any company carefully. The Consumer Financial Protection Bureau (CFPB) offers a helpful list of tips at consumerfinance.gov.

You Could End Up Further in Debt

Debt settlement companies will recommend that you stop payment on your debts during negotiations with creditors. Not only will this hurt your credit score, but multiple late payments will lead to the accrual of late fees and interest.

How Debt Settlement Works

Debt settlement companies make you stop paying the creditors as they negotiate your interest rate and pay your creditors on your behalf. You pay 50%-80% of the balance and are tagged with late payments that get reported to the three major credit reporting companies. Your credit will take a hit, and the derogatory remarks will remain on your credit for seven years.

To learn more about debt settlement, check out this video:

Other Debt Relief Options

The Bottom Line

Do your due diligence if you decide that debt settlement is your best option. Pick a reputable debt settlement service provider.

Before enrolling in any debt settlement program, the Consumer Financial Protection Bureau recommends contacting your state attorney general and local consumer protection agency to check any complaints on file.

FAQs

Bankruptcy or Debt Settlement: Which is Better?

Debt settlement and bankruptcy are for consumers who cannot budget their way out of debt. Both erase the unsecured debt, leaving your credit score in tatters. Either one is not fun.
Bankruptcy has a Chapter 7 and 13. A judge decides the outcome, and the decision becomes a public record.
Debt settlement is typically a private negotiation between your debt settlement company representative and your creditors. It is a private matter but will still impact your credit score.

What’s the Difference Between Credit Card Debt Management, Settlement, and Consolidation?

Credit card debt management plans are set up by a nonprofit credit counseling agency. Many credit counseling agencies offer education and assistance to help people better manage their finances, intending to get them back on the road to financial stability. The credit counselor will set you up with a debt management plan, help you better understand your financial situation, and help you establish a payment plan. The cost usually ranges from $25 to $55 a month. Your repayment plan is set up and managed by the credit counseling agency.
Debt settlement programs typically are for-profit companies and involve the company negotiating with your creditors to allow you to pay a “settlement” to resolve your debt. The settlement is a lump sum less than the total amount you owe. The program asks that you set aside a specific amount of money every month in an escrow account to accumulate enough savings to pay off a settlement that is reached eventually.
Debt consolidation rolls all outstanding debts into one monthly payment, usually with a lower interest rate. Because you’re rolling multiple debts into a single loan, this is referred to as “consolidating” your debt. You take on a new, larger loan and use that money to pay off other existing loans with higher interest rates. It also streamlines multiple credit cards into one payment, making it harder to miss a payment or incur a late fee.