Debt Settlement: How It Works and Drawbacks
It can be difficult to offload a part – or all – of your debt through settlement. It is mentally draining, especially if you feel too deep and there’s no way out. But thankfully, many things are negotiable, and debt is one of them.
Think of the most recent discount you got at a store for an item. Was it 5% off? Perhaps even 10%? Although the original price was supposedly unchangeable, it was possible to pay less. Debts can work similarly. You can get cuts or “discounts” on what you owe.
So, how does debt settlement work? Let’s get started by explaining what debt settlement is.
What Is a Debt Settlement?
There are other names for debt settlement, including debt relief and debt adjustment.
Essentially, a debt settlement is when the borrower agrees with the lender to pay off debt for less than the original amount owed. If the borrower pays back the agreed portion of the loan, the lender forgives the rest of the debt.
Note that not every lender will be willing to accept debt settlements. There are also cases where settling your credit card debt could cause financial harm and give you a bad credit score. Debt settlements also tend to stay on your credit report and appear in your credit and payment history.
The borrower can go through a third-party company to handle the negotiations for the debt settlement. But it is also possible for you to take it without a third party. These third-party companies are debt settlement companies.
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What Is a Debt Settlement Company?
This company acts as the middleman between the borrower and the lender, trying to negotiate a deal that will favor the borrower. They are often used because of their expertise, especially as debt settlement isn’t familiar to many people.
When deciding to use a debt settlement company, review the company’s experience in dealing with creditors and lenders. Reading and understanding the company’s process when negotiating your credit card debt is also necessary.
Finally, every debt settlement company has specific debt settlement programs and offers. It is best to understand their terms so that research will be necessary.
So, how exactly does debt settlement work? What’s the standard process like?
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How Debt Settlement Works
There are some ways to reach debt settlement, whether through a third-party company or on your own.
If you are going through a company – or lawyer – you must pay a fee for services rendered. This payment could come as a one-time fee or a percentage of your current finances, which you will use to pay off debt. This percentage depends on the terms of the third-party company you decide to go with.
Before the debt settlement company begins negotiations, you will begin a payment plan to the collection account of the company. This plan is the money they’ll use to negotiate lump-sum payments with your creditors to help you pay off the credit card debt. They will likely take this from your expenses if they receive a percentage.
If you handle it independently, you can make regular payments to a savings account. When the savings account has become large, you can negotiate lump-sum costs yourself.
Most companies will tell you to refrain from paying the lender, which could push the lender to accept your lump sum. The issue here is that late payments could see your credit score worsen.
If the lender agrees on a settlement with the lump-sum payment, you and the lender can agree to new terms. You will not always likely pay the lump sum in full and at once. Depending on how negotiations turn out, you could also make lower regular payments after paying a part of the lump sum. However, if the lender accepts the lump sum, the best-case scenario could see your debt as ‘paid in full.’
It’s important to discuss the risks involved with debt settlement.
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What Are the Risks of Debt Settlement?
It might seem easy to negotiate a smaller payment to clear your debt. But there are risks involved, and it is important to recognize them.
High Fees
If you use a debt settlement program from a company, you will likely pay some hefty fees. Most individuals work with a company because of the details needed for debt settlement negotiations. But their prices can be high.
Depending on your municipality’s state or local laws, these fees often vary. Some companies will charge as high as 30% of the debt you aim to settle.
In other words, if you want to settle $100,000 of debt, you could pay $30,000 in fees alone! Even if they negotiate your debt down to $50,000, those hefty fees will have you spending an amount so close to the original debt. Note that they take fees are a percentage of the original debt rather than the final payment.
If you are willing to go through the negotiation routes on your own, you may be able to bypass these fees. But note that it can be a daunting task to undertake without professional aid.
The Required Lump Sum
The debt settlement option is very attractive to the lender, and that’s because they get to receive a larger payment now. This option beats waiting a few years for you to make a small monthly payment for longer. But gathering the lump sum amount can be difficult for you.
If you’re set to pay back $100,000 and need to negotiate a $50,000 option, you can’t make minimum payments into the savings account for the lump sum. Remember, companies tell you that you pause payments to the lender. This method increases their incentive to collect the lump sum payment from you.
How long are you willing to pause payments? A few years can be troubling for your credit score, and a few months could be financially impossible if your target lump sum is $50,000. Can you set aside $5,000 per month for ten months? Can you make reasonable efforts to make shorter payments? Or will you have to deal with long-term costs that could last up to seven years?
Debt Settlement Is Not a Quick Solution
While it can look like an easy process on paper, it could take a couple of years. Remember that you have to put significant money into an account, which the lender has to agree to accept to settle the debt.
You’ll need time to gather funds, which could see your debt settlement enter into years. The debt settlement professionals may come to a resolution eventually, but the entire process could take up to seven years.
When this could take, a creditor or collection agency can call you.
Credit Card Debt Can Damage Your Credit Score
There’s a high chance that the debt settlement process can harm your credit score. It can also show up on your credit report. This process is often because you stop making payments to lenders. Many lenders will not negotiate with a customer making monthly payments on time. But once you start falling back on those payments to the lender, your credit starts getting affected. Credit reports also show these issues.
Most creditors will only work out a negotiation if you have fallen back on payments to them. These include charges significantly past the posting date. There’s a chance you could even get sued by your lender for late payments. You will likely get reported to the credit bureaus too. It also doesn’t help that it could show up on your credit report once you have a settled account and further affect your credit scores.
Worsened credit scores will make it even harder for you to borrow money in the future, especially at good interest rates. If your credit report looks bad, you won’t get credit in the future.
Your Forgiven Debt Can Get Taxed
Getting settled debt can be quite relieving, especially because you might have been able to pay it off at a discounted rate. But the Internal Revenue Service won’t look past it just as easily.
According to financial laws in the US, forgiven debt amounting to over $600 is taxable. If your debt exceeds $600, you still have to pay taxes on the difference between what you paid in full and what you owed first.
You Could End Up Paying More than You Owed
This statement might sound like an overreach, but it is potentially possible. With high company rates and low negotiation discounts from lenders, you could owe more money after settling the debt.
Note that interest will add up on multiple debts, even if you stop making payments entirely. There could be other related fees, including late fees and similar bills.
If these charges rack up over the lengthy process, with other factors like high rates, you could pay more than the original debt.
Debt Settlement May Not be Possible
Not all credit card issuers will agree to settle your outstanding debt. While some may agree to sit down and negotiate, they may refuse to have those negotiations with debt settlement companies. Each lender may have certain terms and conditions to improve or reduce your chances of getting your debt settled. There is a chance that the creditor agrees, but the words may be harsh.
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How to Increase Your Chances of Debt Settlement?
Remember that lenders will decide to enter debt settlement negotiations if you default on payments. This decision is why companies tell you to stop making regular payments each month.
Credit card companies need to agree that you are in a dire financial situation before they will agree to negotiations. Appearances matter in this regard, whether you’re working with a professional service or not.
Making timely payments makes you look financially stable enough not to need a debt settlement. You won’t get a negotiation if you have no credit card issues and your account statements show lavish expenditures and shopping sprees.
To raise your chances of requesting a settlement, cut expenditure on the card from your lender to zero (if possible) for a few months. Also, cut off making small payments for your debt so you do not come off as someone looking to dodge their credit card debt obligations.
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How to Negotiate Your Debt Settlement?
If you cannot afford to use a professional or would prefer to handle debt settlement independently, here are steps to help you start negotiations.
- Ensure you haven’t been making small payments or spending a lot.
- Set aside payments into a monthly savings account, which you will use for negotiations.
- Try to save money, at least half of the original debt.
- Contact your lender and ask to speak to a manager in ‘debt settlement.’
- Set up an appointment or discuss the case on the phone.
- Highlight your financial hardship and mention that you have been able to raise and save money to use and settle the debt.
- If the lender agrees to a negotiation, offer to pay 30% of the original debt.
- Remember, you have about 50% of the original debt, so try to keep the negotiation for the settlement lower than that.
- If you cannot get a lower negotiation fee, plan to set aside extra money to fulfill the settlement.
- Once you and the lender have decided, get the agreement in writing.
- Have a lawyer review the agreement to ensure it has no loopholes that could hurt you.
- Only sign the settlement offer if it is exactly as verbally agreed, and proceed to settle your debt.
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Debt Settlement vs. Debt Management
Because of how long credit card debt settlement can take, it is possible to take an alternative route: debt management. Debt management can essentially work out a better plan to pay off the remaining balance on your credit card debt. This plan tends to reduce the loan length and interest charges.
If you worry about the negative consequences on your credit score, a debt management plan could be the better alternative. When undertaking debt management, you will learn to improve and reduce spending habits. These will increase how fast you can pay off debt.
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Conclusion
Debt settlement might be a great idea, but risks and drawbacks are involved, like a bad credit score. It is not the only route to getting debt-free, especially as debt management is an option. You may not have to pay your entire balance with debt settlement, but the cons, like missed payments, may outweigh the pros.
It might be better to pay through debt management and check your options before considering debt settlement as a viable method. Another method could be taking a debt consolidation loan. You can also speak with a credit counselor or discuss it with a credit counseling agency. This option is better than going through a debt settlement program. Before the debt collector comes calling, speak with a financial advisor. This precedent will help you make the right economic choice for the long term and pay your debt faster.
Note that opinions expressed in this article are not financial advice.
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Frequently Asked Questions
How does debt settlement affect my credit score?
Debt settlement can hurt your credit score since you’re not paying the full amount owed. When you stop making payments to your creditors and begin the settlement process, it will be recorded on your credit report, leading to a drop in your score. Additionally, if your accounts are already delinquent, they will reflect on your information, reducing your score.
However, it’s essential to note that you can gradually rebuild your credit as you complete the debt settlement process and settle your accounts. Your credit score can improve over time with responsible financial practices, like making timely payments on remaining debts and avoiding new ones.
How long does the debt settlement process take?
The duration of the debt settlement process varies from case to case. It can take several months to a few years to complete, depending on factors such as the amount of debt, your ability to save for settlements, and negotiations with creditors.
You’ll typically make monthly deposits into a designated savings account during the process. The time it takes to accumulate sufficient funds for negotiation depends on your financial situation and the intensity of your debt settlement efforts.
Working with a reputable debt settlement company or financial advisor is important to ensure a smoother and more efficient process. They can guide you through negotiations, offer expert advice, and help you achieve your debt settlement goals in a timely manner.
Can I continue using my credit cards during debt settlement?
In most cases, it’s best to stop using your credit cards during a debt settlement. Continuing to use them can signal to creditors that you’re not experiencing significant financial hardship, making them less inclined to negotiate. Additionally, accumulating more debt can hinder your ability to save for settlements and prolong the process.
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