Debt Settlement: Is it the Cheapest Way to Get Out of Debt?

The average American has a little over $90,000 in consumer debt, though some people owe much more than that. For those who are in desperate need of debt relief, debt settlement may be a viable solution. Debt settlement is the process of reducing the balance of existing debts to a lower total amount. It’s a way for people to get rid of debt, save money and regain control over their finances.

Still, debt settlement isn’t for everyone. Before attempting to settle any debts, it’s important to understand how it works, the risks and what other options exist.

How Debt Settlement Works: The Process, Costs and Risks

Debt settlement is a form of debt relief. When done right, it’s one of the best ways to reduce or even eliminate debts entirely. The debt settlement process involves negotiating a settlement offer with creditors or lenders to reduce certain debts to a fraction of the current total balance owed.

Some people choose to handle debt negotiation on their own, but it’s often easier with debt settlement services. A debt settlement company is a third-party, for-profit agency that negotiates with an individual’s creditors on their behalf.

The company will typically tell the borrower to stop making payments on their accounts to settle debt. This is because most creditors and lenders will only agree to settle delinquent debts. Allowing your accounts to go delinquent will initially cause your credit score to drop. Debt settlement companies pitch their services as one step backward on your credit score and two steps forward towards financial freedom (i.e. getting out of debt).

While the debt settlement company negotiates, the borrower begins making payments into a dedicated account. The company will then use this account’s money to distribute payments to the creditors or lenders. Only rarely will the borrower pay their lenders directly.

Any settled debts will come with new terms and conditions, which the borrower must agree to before moving forward. Once agreed, the debt is considered “settled.”

At this point in the settlement agreement, the borrower will start a payment plan for a set amount of money each month until there is no more balance on the account. Sometimes, they may have to make a single lump-sum payment for the entire balance. In others, they can make installments over a period of time. They will also pay the debt settlement company a fee for its services.

How Much Does Debt Settlement Cost?

The cost of debt settlement depends on a few factors, such as the types of debt and the amount owed.

Most debt settlement companies charge between 10% and 30% of the enrolled debt (any debt you enroll into the program). Say, for example, you enroll $30,000 in the program. The company will charge based on that amount, not the amount you owe after settlement. In some cases, debt settlement can be cheaper than other debt-relief options.

A few debt settlement companies charge a flat fee for their services, but this isn’t that common. Some will charge based on the end result or the amount saved instead of the amount enrolled.

Whatever their payment system is, these companies cannot charge anything until after the process is complete, according to the Federal Trade Commission (FTC).

What are the Risks?

Debt settlement is a solid option for people who need help with a substantial amount of debt. However, debt settlement strategies do come with their share of risks. Here are the main ones:

  • Damaged credit. Any account that shows up as “settled” on a credit report will hurt your credit score. Plus, since you’re not making payments during the process, your creditors will report this to the credit bureaus. Late or missed payments can impact your credit score for up to seven years. The higher your original credit score, the bigger the drop.
  • Harassing calls from debt collectors. Once you default on payments, the accounts will be sent to collections. When this happens, you may start receiving calls from collection agencies
  • Lawsuits. If they consider the debt worth their while, your creditors or lenders could sue you for not making payments. This could lead to garnished wages.
  • Taxes. The Internal Revenue Service (IRS) may view any debt that’s settled for less than the original amount as taxable income. This means you may have to pay taxes on the difference between what you owed and what you’re now paying.
  • Additional costs. Late fees and interest will still accrue during settlement on the enrolled accounts. According to the Consumer Financial Protection Bureau, these penalties and fees could cancel out any savings you may have otherwise had.

The debt settlement process is complicated and takes between two and four years. Because creditors and lenders are not obliged to accept it, it does not always work.

For example, some lenders, such as Chase Bank, will not work with debt settlement companies at all. Instead, they’ll only work with the borrower or a nonprofit credit counseling agency.

However, debt settlement could save you a lot of money if all goes well. In fact, the average consumer sees a total debt reduction of 33.2% due to debt settlement.

What Percentage Should I Offer to Settle Debt?

Be prepared to negotiate if you want to settle your debts without a third-party agency. Start by explaining your situation to your creditors and lenders about why you need the debts settled. They may be willing to work with you.

Ask to settle the debts for a lower percentage than you’re willing to pay. Generally, you should try to settle debts for around 30% of what you owe. Remember, this is what debt settlement companies will charge you; that’s why it’s a good target to aim for. If the lender or creditor suggests 50% or above, try to settle other debts instead. Upon reaching an agreement, get the new terms and amounts in writing.

Debt Settlement vs. Making the Minimum Monthly Payments

Debt settlement may take several years but paying off debts by making the minimum monthly payments can take decades. This is due to a few factors, including:

  • Interest rate on the account
  • Starting amount of debt
  • If you miss or are late on any payments (late fees add up)

Although paying the account minimums may work for a while, this isn’t a good long-term strategy. You will pay much more in interest over time by only paying the minimums. This ultimately keeps you in debt longer and makes it harder to save money.

Plus, most types of debts have compounding interest. Compounding interest is interest that’s based on the current principal balance and the previously accrued interest on the account. Depending on the account, it can build up daily, monthly or annually.

The longer your accounts carry a balance, the higher the compounding interest will be. That’s why it’s better to pay off these debts as soon as possible. Plus, if you miss even one payment, the interest will compound, thus increasing the total amount you owe.

Making only the minimum payments could also hurt your credit score. For one thing, credit utilization accounts for 30% of your FICO Score. Payment history also has a major impact on your credit. Even one missed or late payment could cause a noticeable drop.

Ultimately, paying the minimum monthly balance each month is more profitable to your creditors than it is to you.

Debt Settlement Company vs. Credit Counseling

Credit counseling is a low-cost or free service offered by government and nonprofit agencies. Some credit card companies also partner with and help fund these agencies.

These agencies offer many services, including debt management plans (DMPs). Debt management plans are a good way to reduce the interest rate on existing accounts. This makes it easier to pay off the principal balance on those accounts and get out of debt.

Credit counseling is best for those who:

  • Owe between $2,500 and $15,000 in unsecured debt.
  • Need to reduce their interest rates so they can make their monthly payments and pay down debt faster.
  • Want to pay off debt without defaulting on payments or impacting their credit score.
  • Would benefit from things like late fee waivers.
  • Seek other assistance such as budgeting, credit management, and financial counseling.

Not everyone qualifies for credit counseling, even if they’re facing a proven, significant financial hardship. However, credit counseling is typically much more affordable than debt settlement. You may end up still having to pay the full amount of your debts, however.

Debt settlement is better for people who owe $15,000+ in debt and need to lower their total principal balance rather than their interest rate. Like credit counseling agencies, a legitimate debt settlement company will also offer other financial resources and counseling.

Read also: How to Pay Off $20,000 in Credit Card Debt

For more information, check out this article on credit counseling. Or contact a credit counseling agency like the National Foundation for Credit Counseling to see what they offer.

Debt Settlement vs. Debt Consolidation

Debt consolidation is the process of taking multiple debts and combining them into one lower-interest account. With debt consolidation, you pay a fixed monthly payment once a month rather than juggle multiple monthly payments. This makes it easier to manage the debt.

Many private lenders, banks, and credit unions offer debt consolidation loans. However, you’ll need a good credit score to qualify for the best rates.

Like debt settlement, debt consolidation is usually best if you have a lot of consumer debt. This includes things like medical bills, personal loans, credit card debt, or student loans. It also helps those who need to get a handle on their debts and start paying them down.

Unlike debt settlement, debt consolidation doesn’t have as big of an impact on your credit score. It’s also usually less expensive. However, depending on the loan terms and your ability to make payments, it could still take years to pay off the new loan.

Debt Settlement vs. Bankruptcy

Bankruptcy is another way to get rid of debt, but it’s not for everyone.

A Chapter 7 bankruptcy can eliminate most outstanding debts. Some of the forgiven debts include personal loans, credit card debt and medical debt. Once filed, the court will put an automatic stay in place. This keeps most debt collectors from pestering you with collection calls and prevents creditors from filing any lawsuits against you.

Bankruptcy usually takes around six months to complete, making it much faster than debt settlement. Since it’s faster, it’s also possible to start rebuilding credit sooner than with debt settlement.

However, not everyone is eligible for bankruptcy. To qualify, you must:

  • Not have filed for a Chapter 7 in the past eight years or a Chapter 13 in the past six years.
  • Prove your income is below a certain threshold for your state.
  • Complete a credit counseling course within six months.

Besides this, there are a few other disadvantages to filing for bankruptcy.

On average, bankruptcy attorneys often charge upfront and cost between $1,000 and $3,000. For another, you must liquidate any non-exempt assets to pay off debts. This includes things like cash, inherited assets, stocks and bonds, and vacation properties.

Read also: 10 Ways to Cut Bankruptcy Costs

On top of that, a Chapter 7 bankruptcy can remain on your credit report for up to 10 years. It’s also a matter of public record, so it may limit other opportunities for you in the future. This includes future employment since many companies use bankruptcy as a qualifying factor for employment.

With debt settlement, anyone who can demonstrate qualifying financial hardship, such as a lost job, may be eligible. When it works as intended, the individual ends up with less debt and can even save money. Plus, on the creditors’ side, they get more money than they might have if the borrower filed for bankruptcy instead.

To learn more about the differences between debt settlement and bankruptcy, watch this video:

Other Options for Managing Debt

  • Peer-to-peer lending: This type of lending does not require a financial institution. Instead, a borrower and an investor work together to establish the borrowing limit and terms.
  • Balance transfer credit cards: The purpose of a balance transfer credit card is to move debt from a high-interest credit card to a low-interest credit card. Some balance transfer cards have an introductory period with 0% APR. This makes it easier to pay off the debt without worrying about interest.
  • Borrowing from friends and family: Borrowing from a loved one has a lot of potential benefits. For one thing, there’s usually no interest. For another, there’s often more flexibility and a longer repayment period involved.
  • Debt Management Plans (DMPs): Some credit counseling agencies offer debt management plans. A Debt Management Plan is a customized financial plan based on your personal finances, including your current debts.

The Bottom Line

Overall, if you need help reducing your debt, debt settlement may be a good option. Most people who use a debt settlement company see between a 10% and 50% reduction in what they owe. After taking out the company’s fees, many people still save money due to debt settlement.

Debt settlement can be risky and damage your credit score. However, it can provide the financial relief you need if you’re struggling with large amounts of debt. Before choosing any form of debt relief, consider other options like debt management plans or credit counseling. That way, you can choose the one that’s right for you.

FAQs

How Do You Negotiate a Debt Settlement Program Yourself?

If you negotiate a debt settlement yourself, you may be able to pay down debts sooner than with a company. Keep in mind that your credit score will still be impacted since you won’t be able to make payments during the process.
Before reaching out to your creditors or lenders, make sure to know what you want. Calculate how much you can realistically afford to pay each month. Use this to help determine the percentage you’d like to settle the debt for.
Once you’ve done this, contact your creditors. Stay calm, polite, and focused on what you need. Be prepared to explain your situation to the person on the other end of the line. If they’re not accommodating, try to speak with a different representative later.
If negotiations are going well, see if you can get your accounts marked as “Paid as Agreed.” This will do the least amount of damage to your credit score. Be sure to get any changes or verbal agreements in writing. That way, everyone is held accountable.
Finally, make sure you never miss any payments. If you do, this may cancel out any negotiations you’ve successfully made

How Long Does Debt Settlement Stay on My Credit Report?

A settled account will stay on your credit report for up to seven years from the day it first became delinquent. If the account was never reported as delinquent, then it’ll stay on the report for seven years after it’s settled.

What is a Debt Settlement Scam?

A debt settlement scam is an agency or individual that promises people who are burdened financially to reduce or eliminate their debts. They may also make other impossible promises like removing negative marks from your credit report or reducing interest rates.
According to the FTC, these scams often charge upfront fees for their services, even though it’s illegal to do so. They often encourage the consumer to cut off all communication with their lenders or creditors. Despite what they say, most scam companies never reach out to your creditors.

How Can I Tell if a Debt Settlement Company is Legitimate?

Here are a few easy ways to tell if a debt settlement company is legitimate:
The company does not charge upfront for its services.
It does not guarantee to settle your debt, nor does it promise to lower interest rates.
The company’s timeframe for settling debt is consistent with the industry standard, which is between two and four years.
It does not tell you to stop communicating with your creditors or lenders.
There are real customer reviews on sites like the Better Business Bureau (BBB) about the company.
The company does not have many unresolved consumer complaints online.
When in doubt, contact the CFPB or another local consumer protection agency. Ask them if there are any negative reports about the company. In some states, legitimate debt settlement companies must also be licensed, so check for that, t

Can I Repair My Credit After Debt Settlement?

Yes, but it will take some time. Usually, you’ll have to wait to make major, positive changes until after completing the debt settlement program.
Pay all your bills on time to improve your credit after debt settlement. If you need to start building credit from scratch, look for a secured credit card or store credit card. You don’t need to use the cards to build credit, but you will need to activate them. Avoid applying for too many cards at once, as too many hard inquiries can temporarily hurt your credit score.
Another option is to contact your creditors about the accuracy of the derogatory marks on your credit report. If the creditor does not respond within a certain period, you can request that the credit bureau removes the mark.
If you used a debt settlement company to negotiate your debts, reach out to them as well. They may have other suggestions or resources to help you repair your credit.

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