Pros and cons of debt settlement

Debt settlement is when you negotiate with a creditor to pay off a debt for less than you owe. Private, for-profit companies typically offer this service, and it may be an option if you have high debts that you’re unable to pay down.

If you need help paying off debt, consider the pros and cons of debt settlement, as well as some other debt management strategies.

Taking out a debt consolidation loan can be one way to get a handle on your debt payments. Credible makes it easy to see your prequalified personal loan rates from various lenders.

• What is debt settlement?
• Pros of debt settlement
• Cons of debt settlement
• Alternatives to debt settlement
• Personal loans to pay off debt
• How to move forward with debt settlement

What is debt settlement?

Debt settlement is a type of debt payoff strategy that works like this: A company charges you a fee to negotiate a settlement amount with your creditor — a lump-sum payment you agree to make in order to have the debt wiped clean. This amount is typically less than your outstanding balance.

With debt settlement, you’ll usually need to start depositing money into a designated escrow account each month. Once your balance in that account reaches a certain threshold, the company will reach out to your creditor to negotiate on your behalf.

There’s no hard and fast formula for how much a creditor will accept with a settlement. A variety of factors typically come into play, including how much you owe and how long your account’s been active.

Pros of debt settlement

The biggest benefit of debt settlement is that it may allow you to pay off your debts for less — sometimes significantly less — and you could even avoid bankruptcy using this strategy. Debt settlement has some other advantages too. Let’s take a look at each one in-depth.

You may be able to pay off your debts for less

The idea behind debt settlement is that a creditor would rather get a small payment than nothing at all. For this reason, you can typically expect a settlement to cost less than your total overdue debt — at least if the creditor agrees to it.

More than 98% of settlements result in savings that outweigh the fees the settlement company charges, according to a study by the American Fair Credit Council. Most consumers see a settlement that’s around 50% less than their owed balance and save about 30% once fees are factored in.

Let’s take some real-life examples into account from a report by The Association of Settlement Companies. Consumer A owed $28,668. They were able to settle for $12,518, plus $2,423 in fees, after 30 months. They netted nearly $14,000 in savings. Those with lower balances may see less of a benefit by using a debt settlement service. For example, in the same TASC report, Consumer B had a balance of $3,512; they settled for $2,459, plus $158 in fees, only to save $895 after 30 months.

CFPB REPORTS AVERAGE HOUSEHOLD PAYS $1K IN CREDIT CARD INTEREST AND FEES ANNUALLY

You might avoid bankruptcy

Bankruptcy can have serious long-term consequences and can remain on your credit report for up to 10 years, making it harder to get a loan, buy a car, or even find employment or housing for many years to come. Bankruptcy should only be considered as an absolute last resort. So if this is a direction you’re headed in, debt settlement might help you avoid it. Just keep in mind that it takes about three years to get out of debt with most debt settlement programs, according to TASC.

It may help you pay off your debts faster

If you have a particularly large amount of debt, it could take many years or even decades to pay it down with just small monthly payments. With debt settlement, you may be able to speed up this timeline.

The debt settlement process typically takes around three years, while debt management plans (which we’ll explore below) take around five. Debt consolidation loans can also take up to five years to repay, according to an analysis by the American Fair Credit Council.

LOOKING TO PAY DOWN HIGH-INTEREST DEBT? HERE ARE 3 EXPERT-APPROVED METHODS

It may stop collection calls

If you’re tired of getting calls from debt collectors, settling your debt or even agreeing to a settlement plan may stop them. Just be sure to get your plan in writing, and make a note of the date you agreed to it.

Cons of debt settlement

Debt settlement has several drawbacks you’ll want to think about before pursuing it. Fees, taxes, and credit consequences are just a few of the disadvantages to consider. Debt settlement companies have also been known for unscrupulous and even fraudulent practices in the past, so it’s important to choose a reputable company to work with.

You’ll have to pay fees

Debt settlement services aren’t free. You’ll pay a number of fees for debt settlement, including set-up fees, monthly fees, and third-party escrow fees. And you may rack up additional interest charges and late penalties from your creditors if the debt settlement company advises you to stop making payments. If you’re not careful, these costs could reduce any savings your settlement nets you.

You might not get what you ask for

Creditors don’t have to agree to a settlement, and some may outright refuse to work with companies that offer these services. So despite what a company says, they may not be able to settle your debts for less — or at all — in the end.

Additionally, scams are common in the debt relief industry. The Consumer Financial Protection Bureau recommends avoiding companies that charge upfront fees, guarantee a settlement, or tell you to stop communicating with your creditors.

It will hurt your credit

While paying off your debts is certainly a good thing in the long run, debt settlement — at least the way most companies do it — can actually hurt your credit in the short term. That’s because settlement companies often require you to stop making payments to your creditors while you save up for your settlement. This can cause late payments, penalties and fees, lead to collection calls, and lower your credit score.

You may face tax consequences

Settling your debt could be considered "forgiving" part of your debts if you settle for less than you owe. In some cases, the IRS may count the forgiven amount as taxable income, which could increase your annual tax burden.

But it may be possible to claim insolvency when reporting to the IRS. Insolvency is when a taxpayer’s total liabilities exceed their assets. By claiming insolvency, you may not be responsible for paying taxes on the forgiven debt. Speak with an accountant or tax professional about this possibility before moving forward with debt settlement.

Alternatives to debt settlement

Debt settlement isn’t right for everyone, and it certainly comes with some notable risks to consider.

If debt settlement doesn’t feel right for your situation, you can explore other options, including:

• Nonprofit credit counseling — This is financial counseling offered by nonprofit organizations and agencies. Credit counselors can help you budget, advise you on paying down debts, and help you set up payment plans, among other services.
• Enrolling in a debt management plan — Credit counselors set up debt management plans, which may involve negotiating a lower interest rate or extending your payoff time. You then make a single monthly payment, and the counseling agency will pay your creditors on your behalf. But you may have to pay a fee for this service.
• Balance transfer credit cards — Some credit cards allow you to transfer balances from other credit cards for a small fee. You’ll usually get a low or 0% interest rate on these cards for a certain amount of time, which could cut down on your long-term interest costs (as long as you pay off the balance before that introductory rate expires). But you’ll typically need good credit to qualify for a balance transfer credit card with a 0% APR offer.
• Debt consolidation — Consolidation is when you take out a loan (usually a personal loan, second mortgage, or home equity line of credit) and use it to pay off your other debts.

Bankruptcy may also be an option, but you should only consider it as a last resort. When you file for bankruptcy, certain debts are discharged — meaning you don’t need to pay them back. But there’s a catch: The bankruptcy will remain on your credit report for up to 10 years. This could make it hard to achieve financial goals, like buying a house, taking out life insurance, or even getting a job or apartment.

HOW TO GET A PERSONAL LOAN

Personal loans to pay off debt

You may opt to use a personal loan to pay off your debts. This strategy is often referred to as consolidating, since you’re basically rolling all your debts into one single loan balance.

Consolidating your debts can make it easier to pay them off. You’ll only have one monthly payment to keep track of, and it could mean a lower interest rate too. But this depends on the rates on your current debts, as well as what rate you could qualify for on a loan.

You also may be able to reduce your monthly payment amount by opting for a longer repayment term. Keep in mind that this will typically mean paying more in long-term interest.

How to move forward with debt settlement

If debt settlement is something you’d like to explore, be careful who you work with. Scams are common in the debt relief industry, so check with your state’s attorney general office and your nearest consumer protection agency to see if a company has been flagged or investigated. You can also watch out for the red flags the FTC says are signs of a scam.

Once you’ve determined a reputable company, make sure you understand the fees you’ll owe, as well as the time frame of your settlement. The process typically takes a few years. If your debt is settled, you can expect it to remain on your credit report for seven years.