The average American has a little over $90,000 in consumer debt, though some U.S. households owe much more than that. If you need debt relief, debt settlement is often the fastest solution.
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What You Need to Know About Debt Settlement
So, what is debt settlement? It is simply the process of renegotiating, settling, or in some way altering the terms of a borrower’s debt to a creditor or debt collector. Many people aren’t aware that credit card companies and other lenders are often willing to negotiate and lower the total amount of debt you owe them. Compared to alternatives such as debt consolidation loans, credit counseling, debt management and bankruptcy, it’s the fastest way to eliminate unsecured debt.
It also may be called debt resolution, debt reduction, debt negotiation or a debt consolidation program.
How Debt Settlement Works
- The consumer consciously and voluntarily withholds payment to creditors
- The consumer makes monthly deposits into a specialty savings account
- The provider negotiates new terms with creditors on behalf of the consumer
- A settlement offer is reached that the consumer approves
- Consumer makes payment from their specialty savings account towards that settlement
- The process is repeated until all debts are settled
There are two ways to settle debts:
- Hire a debt settlement company: A third-party debt settlement company (also called debt relief companies) will meet with you to discuss your financial situation. Then the company will contact your creditors and negotiate settlements and payment plans on your behalf. They do the heavy lifting, and in exchange, you pay them a fee ranging from 15% to 27% of the total debt settled.
- DIY debt settlement: The settlement process is the same. However, you contact the creditors and handle debt negotiations and settlements independently. This can be a good option if you’re a skilled negotiator and have the time to treat it like a part-time job.
READ MORE: Debt settlement vs. debt consolidation
Is Debt Settlement Worth It?
Yes, debt settlement can be a better option than Chapter 7 bankruptcy, which will decimate your credit score. 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 27% of the enrolled debt (any debt you enroll into the program).
Here is a comparison of how much you’d spend — and how long you’d be making payments — if you have $25,000 in debt:
|Debt settlement||Credit counseling||Minimum monthly payments|
|Total debt repaid||$13,800||$25,000||$25,000|
|Months to pay off or settle all debts||48 months||48 months||400+ months|
READ MORE: Debt settlement vs. Debt Management Plans
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).
If you want to try your hand at debt settlement but don’t want to pay, it’s possible to do it yourself by calling your creditors to negotiate.
READ MORE: How to pay off $20,000 in credit card debt
Who It Helps
Only unsecured debts are eligible for debt settlement. This includes debts like credit card bills, personal loans, medical bills and some private student loans. But it won’t work for some unsecured debts, including child support, alimony and back taxes.
Pro tip: Secured debts, like car loans and mortgages, are not eligible for debt settlement.
This means if your debts are primarily secured debts, debt settlement isn’t a good choice for you.
READ MORE: Debt settlement qualifications
When It Makes Sense
But if you have more than $7,500 in unsecured debts (like credit card bills) or $1,000 or more in payday loans and are experiencing financial hardship, debt settlement could be the best way for you to tackle your debt problems.
The debt settlement process is complicated and will usually take between one and four years to complete a program successfully. Because creditors and lenders are not obligated to settle debts, it does not always work.
However, debt settlement could save you a lot of money if all goes well.
According to the American Association for Debt Resolution, debt settlement provides an average of $2.64 in consumer savings for each $1 fee assessed.
In addition, more than 98% of settlements result in a debt decrease that is greater than the fees charged.
What Does a Debt Settlement Company Do?
A third-party debt settlement company will be the middleman between you and your creditors.
First, a legitimate debt settlement company will review your information to determine whether debt settlement is your best option. A few other debt-relief options may better suit your needs, including debt consolidation and bankruptcy. A legitimate company will also know which creditors are open to settlements.
READ MORE: How to choose a debt settlement company
Pro tip: If a debt settlement company tells you they can’t help you, it’s nothing personal. Debt settlement isn’t the best option for every borrower who needs relief. A reputable company will review the debts you have and will be honest about whether or not debt settlement is a viable option.
The company should be forthright and professional, and you need to feel comfortable openly discussing your financial situation with your chosen company. You need to trust that the company offers you the best possible option.
Pro tip: When Credit Summit ranked the top debt settlement services, our top pick was DebtHammer, due to the array of options and helpful customer service team.
READ MORE: DebtHammer review
An effective debt settlement plan can have a lot of benefits, the most important of which is easing the financial burden you’re experiencing. In addition:
- Lower monthly payments Long-term savings because you aren’t repaying the full amount of your debts
- Stop debt collection calls once settlements are in place
- Pay off your outstanding debts faster
- Stop worrying about money
- Settlement agreements may keep you out of court
- It may be the option with the overall lowest cost
- It’s probably a better option than bankruptcy
- There will be mental health benefits as you make progress on repayments
- No charge-offs on your credit report
There are also a few disadvantages.
- Creditors could refuse to settle
- Interest and late fees will add up when you stop making payments
- Secured debts cannot be settled
- You’ll have to be thick-skinned to deal with debt collectors and collection agencies until settlement agreements are reached
- It could take up to four years to complete the process
- The forgiven debt may have tax consequences
READ MORE: Pros and cons of debt settlement
The Debt Settlement Process
After your initial consultation, the debt settlement company will ask you if you are willing to stop making monthly payments on your unsecured debts. (You’ll keep paying secured loans like mortgages and car loans and any routine bills you have.)
Why stop payments? The reason is simple. Most creditors won’t consider settling debts until the account is charged off.
Three things MUST happen before a debt settlement company is allowed to collect its fees. Under FTC law, a fee can ONLY be collected:
- When at least one of the client’s debt obligations has been renegotiated, settled, reduced, or issued new terms AND
- When a written settlement agreement, debt management plan, or other agreement has been made between the customer and the creditor that the client agrees and accepts AND
- When the client has made at least one payment to the creditor following the agreement that the service provider negotiated.
Pro tip: Charged off means that the creditor has given up hope that your debt will be paid, and has notified the three credit bureaus of this. Charge offs are noted on your credit report, will significantly hurt your credit score and do not release you from the obligation to repay the debt.
As you wait for your debts to be charged off, you’ll set up a savings account and deposit all the money you would have been paying your creditors during that timeframe. This will give you some savings to use as leverage in the negotiations.
After each account is charged off, the debt settlement company will start negotiations. Each creditor will be offered a fixed-term payment.
READ MORE: How much does a debt settlement lawyer cost?
You Aren’t Obligated to Approve the Settlement
You must agree to the terms of any settlement agreement. You are not obligated to accept the terms if you aren’t satisfied with the offer. Nothing will move forward without your approval.
After a deal has been reached, you likely will start making payments to the debt settlement company, which will make the payments on your behalf. This will continue until the settled debt has been repaid in full, which customarily ranges anywhere from 12 to 48 months, depending on the total debt settled.
Pro tip: Some settlements (DIY in particular) will involve making a single lump-sum payment instead of repaying the debt over time. This is why setting up a savings account is so important.
Debt Settlement Costs
Most debt settlement companies charge between 15% and 27% of the enrolled debt (any debt you enroll in 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 many cases, debt settlement can be cheaper than other debt-relief options.
Pro tip: Be aware that the Internal Revenue Service (IRS) could count any settled debts as taxable income, so you may not save as much as expected when income tax time rolls around. However, there are often exceptions for people who aren’t financially solvent.
Will It Work for You?
Anyone who can’t make their minimum payments, is currently experiencing financial hardship or has an overwhelming amount of debt is a good candidate.
Plus, if you have debts that have already been charged off or are more than 90 days past due and want to avoid bankruptcy, debt settlement will probably be your best option.
But there are a few other considerations. Ask yourself the following questions:
- Are you committed to getting out of debt?
- Do you have a legitimate financial hardship, and are you willing to openly discuss it with your creditors or a third-party debt settlement company?
- Are your debts primarily from credit cards? While almost all forms of unsecured debt can be settled, credit card companies are most likely to negotiate.
- Can your monthly budget handle the payments? If you negotiate a settlement agreement, then fail to follow through with the payments, you may end up worse off than you were before you started.
If you meet these criteria, set up a free consultation with a debt settlement company to discuss your options.
Don’t Worry Too Much About Your Credit Score
Debt settlement will initially cause your credit score to drop, but the damage won’t be as significant as you fear, and it will eventually rebound. If you’re overwhelmed by debt, you likely have already established a pattern of late payments and high debt utilization ratios, so your credit score is probably already less-than-ideal.
Pro tip: If your credit score is below 600, the impact of debt settlement will be minimal. If you’re worried that you’ll never be able to buy a home or get another loan, stop. This will be true in the short term, but the quicker your debt issues are addressed, the quicker you’ll be able to make major life purchases.
How Much Will Your Credit Score Drop?
How much your score will drop depends on your credit score when you start a debt settlement program. Borrowers with the highest credit scores will see the most significant declines.
For example, here is the estimated impact based on the FICO scoring model:
- A credit score of 730 could drop to 535, almost 200 points
- A credit score of 630 could drop to 545, less than 100 points
- A credit score of 505 could drop to 470, a 35-point drop
How it affects your credit score will also depend on a few additional factors: your number of open accounts and your credit utilization ratio.
Pro tip: You may read that debt settlement will hurt your credit score for seven years. This is not accurate. On your credit report, accounts will be marked as closed, and debts will appear as “settled” or “paid in full.” A “settled” notation won’t affect your credit score. However, it could be a red flag to potential employers or landlords to indicate a pattern of financial difficulties.
It Will Ultimately Help Your Credit Score
Some creditors are willing to negotiate how your settlement will be reported to the credit bureaus. Any accounts marked “paid in full” will look normal to employers.
Your credit score will rise in the long run because your credit utilization ratio will be lower. The faster you pay off your settlements, the quicker your score will rebound. But ultimately, your credit score will depend on what you do after the settlement. Your credit score prioritizes the most recent entries, so responsible use and on-time payments will help your score bounce back.
How Can I Tell if a Debt Settlement Company is Legitimate?
Unfortunately, the debt settlement industry is full of scams, but there are a few ways to recognize legitimate companies:
- There are no upfront fees
- The company does not guarantee to settle debts or lower interest rates
- The timeframe the company gives you is realistic (the industry average is 12 to 48 months). Beware of any company that promises immediate results. It will take at least a few months.
- The company has favorable reviews on sites like the Better Business Bureau.
- The company does not have many unresolved consumer complaints online.
Pro tip: If you’re in doubt about a particular company, contact the Consumer Financial Protection Bureau (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 be licensed, so check on that.
The CFPB also offers some safeguards.
More Debt Relief Options
- Nonprofit credit counseling: A credit counselor will meet with you and set up a Debt Management Plan, but you’ll repay the full total of your debts, and you’ll also pay a monthly administrative fee ranging from $25 to $55.
- Debt consolidation: This involves getting a new personal loan, a debt consolidation loan or a balance transfer credit card and combining your debts into one larger loan. Some balance transfer cards charge upfront fees instead of interest for anywhere from 12 to 18 months. Whether this will work will depend on your current credit score and the total amount of money you owe. It’s possible the new loan may not be large enough to consolidate all of your debts.
- Bankruptcy: If your financial issues are severe, Chapter 7 bankruptcy may be your only option. It will decimate your credit score for up to 10 years, but it will also provide a financial reset.
READ MORE: 10 ways to cut bankruptcy costs
The Bottom Line
If you need help reducing your debt, debt settlement is a good option. Most people who use a debt settlement company sees an average debt reduction of 30% on the original debt, including fees, according to the American Fair Credit Council.
If you’re struggling with large debt, debt settlement can provide the relief you need. Just make sure the company you choose is easy to work with, accessible and can answer your questions upfront. Choosing the right company gives you the best shot at long-term success.
It is always better to pay your debt in full. Having debts noted as “settled” on your credit report will lower your credit score. However, if you can’t repay the debt at all, settlement will always be better than defaulting, which will hit your credit score much harder. I
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.
Yes, but it will take some time. Usually, you’ll have to wait to make positive changes after the debt settlement program is completed.
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 must activate them. Avoid applying for too many cards simultaneously, 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, also reach out to them. They may have other suggestions or resources to help you repair your credit.