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Debt settlement is a type of debt relief in which you negotiate with your creditors or use a company to negotiate on your behalf to have your creditors accept less than the amount you owe. You’ve probably seen or heard commercials advertising debt settlement and debt relief programs that claim to save you thousands of dollars. What these advertisements don’t tell you is how debt settlement programs work and the consequences of debt settlement.
How Does Debt Settlement Work?
Most debt settlement programs, whether you need credit relief or your loans settled, follow the same basic steps to get creditors to negotiate your debt. Your debt settlement program will have you stop making payments on your debt—usually for six months or more, according to the National Foundation for Credit Counseling (NFCC)—to give creditors the impression you can’t afford your debts. Many debt settlement companies will ask you to deposit money into a savings account each month to start saving money that you can put toward an eventual lump-sum settlement agreement.
Once the debt settlement company thinks it can negotiate a lower amount on the debt you owe with the creditor and you have a lump sum ready to pay the hopeful amount, the company will start negotiating with your creditors. If a settlement amount is agreed upon, the amount will be paid and the debt will be considered paid in full.
Unfortunately, debt settlement doesn’t always work, even with some of the self-proclaimed best debt relief programs. Some creditors won’t settle your account and others sell your account to a collections agency that won’t negotiate. In this case, you either have to pay the debt off including all interest and late fees incurred, wait for the statute of limitations to expire on unsecured debt or claim bankruptcy to get rid of the debt.
The Federal Trade Commission (FTC) banned the practice of charging upfront fees, but the rule only covers for-profit debt settlement companies that offer their services over the phone. Some debt settlement programs may still charge an upfront fee, and those companies should be avoided. Today, most national debt relief programs charge you a flat percentage of the debt originally owed when you start the program—usually 13% to 20%—or a percentage of the debt the program negotiated away, sometimes as high as 35%. The companies may charge a monthly fee to participate in the program or an administrative fee to manage the debt relief program.
For instance, if you owed $40,000 before entering the debt settlement program and the company charges 15% of the amount of debt owed, you’d pay a total of $6,000 to the debt settlement company. If the company charges 30% of the debt reduction and the company reduces your debt by $15,000, you’d owe $4,500.
Why You Should Avoid Debt Settlement
Debt settlement programs should be avoided in most cases, whether its credit card settlement or settling loan debt. Even if debt settlement companies are able to reduce your debt by a significant amount, the amount of money you save is usually smaller. The late fees and interest on the accounts you stop making payments on add up quickly. You also have to subtract the fee the debt relief program charges and any taxes you may owe on the amount of debt that is forgiven.
In addition to the direct financial consequences of how much it costs to pay down your debt after settling, fees, and taxes, you should seriously consider the following negative consequences of debt settlement:
- Your credit score may drop over 100 points.
- Debts settled may show up on your credit report as “paid by settlement” which can hurt your credit score.
- If you make a misstep in your debt settlement program, you may lose the savings you set aside.
- Your debt may not get settled for less than what you owe.
- Creditors will be hounding you to make payments on your debt.
- Debt could get sent to collections before it gets settled.
Alternatives to Debt Settlement
There are other options to consider when trying to settle debt and better your financial situation:
Change your financial habits: Reevaluate how you manage your finances, since debt usually creeps up by spending more than you earn each month. Take time to track your income and expenses to make sure you’re spending less than you earn. You can make a budget to take control of your spending, and use the difference between what you earn and what you spend to start paying off your loan or credit card debt.
Debt consolidation loans: You may want to consider a debt consolidation loan to simplify your finances and save money on interest at the same time. With debt consolidation companies, you can borrow money to pay off your other unsecured debts. Debt consolidation loans are usually unsecured personal loans that are repaid over three to seven years. You have fewer payments to make each month. Interest rates vary but can be lower than typical credit card interest rates. Lower rates allow you to put more money toward paying off your debt and pay less in interest charges.
Credit counseling: If you think your debt is unmanageable, consider a credit counseling service. Credit counselors—such as the National Foundation for Credit Counseling—can look at your financial situation and inform you of your options to get out of debt. When looking for a credit counselor, make sure to check qualifications. According to the FTC, most reputable credit counseling agencies are nonprofit. The FTC also advises consumers to look for credit counseling agencies that offer a range of services and are upfront about their pricing if they are not free.
Bankruptcy: If your debt situation is out of control, credit counselors may suggest taking a serious look at bankruptcy. The two major forms of bankruptcy, Chapter 7 and Chapter 13, both allow you to work toward paying off your debt in different ways. If you owe more in "bad" debt than your annual salary, or you can no longer make your minimum payments each month, consult with a credit counselor or a bankruptcy attorney to see if bankruptcy should be considered.