It’s a spiral no one wants to experience, but many have: You lose a job or suffer a costly illness. The bills pile up. By the time your finances stabilize, calls from collectors are pouring in.
In this situation, debt settlement — where creditors agree to settle your debts for less than you owe — may seem like the only fix.
But this strategy carries risks, including a long-term hit to your credit score and no guarantee of resolving your debts. Your finances may seem beyond repair, but debt settlement could make things worse.
There are only a couple scenarios where settlement makes sense, says Michael Bovee, president of Consumer Recovery Network, a debt settlement company.
1. You had one temporary setback. If you’ve fallen behind on one credit card, but otherwise stayed on track with bills, you may be a candidate for settlement, Bovee says. Your debt should be at the collections stage, signaling hardship to the creditor.
2. You’ve tried everything else. You struggle to make monthly payments toward your debt and don’t qualify for bankruptcy, Bovee says.
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DIY settlement and risks
If you decide to settle, negotiate yourself instead of paying a debt settlement company to negotiate for you, says Elaina Johannessen, program director at Minnesota nonprofit credit counselor LSS Financial Counseling. Negotiating on your own requires persistence and patience, but you’ll typically reach settlement faster.
Most people think bankruptcy is the option of last resort, when it’s actually the option of first resort
You also need to have some cash on hand to make debt settlement work. Debt settlement plans require you to pay the creditor a lump sum or agree to a payment plan.
Throughout the process and until you settle, your credit score will drop. The settlement stays on your credit report for seven years, showing that you paid less than what you owed.
Alternatives to settling
Settlement is not a solution for overwhelming debt — the kind that keeps you up at night.
For many people Chapter 7 or 13 bankruptcy can be a faster and less scarring way to deal with debt, although it carries a stigma.
“Most people think bankruptcy is the option of last resort, when it’s actually the option of first resort” for people buried in debt, Bovee says.
A debt management plan from a nonprofit credit counselor can also give you relief.
To make debt management plans work, you must have steady income, says Tasha Bishop, director of operations and development at Ohio-based Apprisen, a nonprofit credit counseling agency. That’s because debt management plans usually require fixed monthly payments to creditors for three to five years.
Both bankruptcy and debt management plans not only give you a fresh start, but you may also learn to better manage your money through required education.