Debt Settlement


What is Debt Settlement?

The Bottom Line: Debt settlement is the best solution for certain people with a serious debt problem. If you have more than $10,000 in unsecured debt and are struggling to make your payments or feel that you are about to reach that point, you should consider debt settlement. Debt settlement offers you the lowest total costs and the shortest time for getting out of debt while avoiding bankruptcy. It also offers the lowest monthly payment for any debt relief option. Designed for people who are experiencing some kind of financial hardship, it is not “an easy way out.” There is no gain without some pain.

Debt settlement, is also called debt negotiation or debt resolution. Settlements are negotiated with your unsecured creditors. Commonly, creditors agree to forgive a large part of what you owe. Settlements often are obtained that reduce the debt by 40% to 60% of what you owe, though results can vary widely.

When settlements are finalized, the terms are put in writing. It is common that you will make one lump-sum payment in exchange for the creditor agreeing that the debt is now $0 and the matter closed. Some settlements are paid out over a number of months. In either case, as long as you do what is agreed on in the negotiation, that debt is paid off and will show on your credit report as $0 balance.

Settling Debt

There are two ways to go about settling your debt. You can negotiate directly with your creditors or you can work with a professional debt settlement company.

Debt negotiation professionals generally are more successful at negotiating a settlement than individuals. That is especially true the more you owe or the greater number of creditors you owe.

They have the experience to know how each creditor works, what it is willing to settle for, and when a creditor will take a settlement in payments or demand a lump-sum.

Reputable settlement firms track all the settlements they negotiate with creditors so they know which account to settle first, what the best deal is, and who to contact to get the best deal. Timing can be crucial, too, and professionals know what time of the month, quarter, or year is most favorable for getting the lowest settlement from a particular creditor.

For settlements that are paid out over a number of months, a professional has the experience to know what the lowest monthly payment that a creditor will accept, and how many months a creditor is willing to stretch out the payment.  Calling the 800 number on the back of your card and trying to do negotiate for yourself doesn’t tell you this.  Working with a professional does.

A large, reputable debt settlement firm can work on accounts in bulk. Settling one account is good, but settling 100 accounts at once gives the professional leverage. By making the process more efficient for the creditor, which saves them money, a professional that can bulk deals together is able to secure the best settlement percentages possible. 

The best settlement firms are able to develop rapport with the creditors. They are speaking with the specific collectors at each collection agency every day, working hard to establish and maintain solid relationships. 

No Up-front Fees

Only work with a debt settlement firm that does not charge up-front fees. Federal law prohibits any debt settlement firm that telemarkets its services to charge up-front fees.

Separate from legality, it makes no financial sense to work with any firm that charges you fees in advance, when you can find reputable, experienced settlement firms that won’t charge you a fee for any account they settle until after the settlement is finalized.

A firm that charges you for their services only after an account is settled has a higher motivation to settle your debts.

Debt Settlement Pros

The biggest benefits of debt settlement are:

  • Reducing your total debt
  • Getting out of debt faster
  • Lowering the size of your required monthly payment

If your debt is so large that you can’t pay it off, you may you consider bankruptcy. Settling your debt is a much less drastic option. Although it harms your credit, the damage is much less severe than filing bankruptcy. Also, settlement is not a public record the way that bankruptcy is.

Typical settlement savings are in the range of 50% of what you owe. Your mix of creditors and the settlement provider you choose could produce very different results. These dramatic savings are based on your current account balances.

Compare your total costs in a settlement program to your total costs paying off your debts making the size payments you make currently. When you factor in all the interest you would pay your creditors, and the number of the years it would take you to pay everything off, the savings from debt settlement are even larger. Your monthly payment in a settlement program is lower, too.

What Are the Drawbacks?

The two main drawbacks to settlement are the:

  • Potential for having the amount you settle considered taxable income
  • Damage to your credit

Balances that are forgiven are usually considered taxable income by the IRS. However, if you meet the IRS' definition of hardship, at the time of your debt settlement, you may not have any tax obligation for the forgiven debt.

Seek advice from your tax adviser on Cancellation of Debt Income, and be sure to ask about IRS Form 982. Form 982 can be used to excuse your requirement to declare the forgiven debt as income.

Even if you have to pay taxes on the settlement, it is far cheaper than having paid back the debt in full. Say, for example, you owe $10,000 and settle the debt for $5,000. You may have to pay taxes on the $5,000 you saved, if you aren't eligible to use the Form 982, but the taxes you could owe will be far less than paying back the full $5,000.

Settlement harms your credit because you are not making monthly minimum payments to your creditors during your settlement program. This results in delinquencies appearing on your credit report which lower your credit score. The experience can also be stressful, since you may get collections calls and could even be sued. You have to balance those concerns out against the significant savings.

Many people entering a settlement program already have damaged credit, due to late payments and carrying a lot of debt. For someone whose credit is already damaged, the benefit of saving money can be far more important than concerns about harm to an already damaged credit score.

What Kinds of Debt Can Be Settled?

Credit card debt settlement is the most common type of debt that is settled, although medical debts and other personal loans can also be settled. Mortgages, car loans, and other secured loans can’t be settled. Secured loans are backed by collateral that the creditor can repossess if payments are not made as agreed.

Federal student loans also can’t be settled due to federal law. Private student loans might be eligible. Loans made directly by a school may be eligible, so ask your debt consultant. If settlement is not an option for your student loans, contact your lenders to request consolidation, deferment, or forbearance.

Action Plan

If you are carrying over $10,000 in debt, look into the different options for getting out of debt. What is best for you depends on your income, assets, credit rating, and your specific goals.

  1. Start by evaluating your budget, so you only commit to a debt solution with a payment you can afford to make each month.
  2. Compare your different options, before you make a decision. Use the free Debt Navigator tool, to evaluate your situation and find the solution best suited for you.
  3. Only work with a reputable debt relief company, for sure one that does not charge any fees up-front.