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How Does Debt Settlement Work?

Credit Score, Paying Off Debt, Personal Finance
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How Does Debt Settlement Work?

If you settle a debt, you get a creditor to agree to accept less than the amount you owe as full payment. But a lot of painful things have to happen first.

If you are worried about falling behind — but haven’t yet — you won’t be able to settle. A creditor or collector is not going to accept less than you owe if there’s reason to believe you could pay the full amount that you originally agreed to.

Debt settlement comes into play only when you have many late or skipped payments and possibly collections accounts. Your credit scores will have been shredded; you feel hopelessly behind; your income isn’t enough to keep up with your debt obligations.

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As you explore debt settlement, beware: Consumer finance groups warn in very strong language that it’s risky, doesn’t work for many people, and may just prolong your financial pain. It won’t stop late fees, collection notices or even threats of being sued while the process plays out.

More on debt and credit

Debt consolidation can help your credit if it helps you make on-time payments or shrinks balances on revolving accounts, especially if credit card balances were near their limits. Your credit may be hurt if you run up credit card balances again, close most or all of your remaining cards, or miss a payment on your debt consolidation loan.
Bankruptcy and debt settlement can reduce or eliminate credit card debt, but they severely impact your credit. Debt management reduces interest rates, and its effect on your credit is less severe. Debt consolidation can reduce interest rates as well.
Reduce your debt in four steps: 1. Get a handle on what you owe. 2. See how much you can pay over the minimums. 3. Consider options such as payoff strategies and debt consolidation. 4. Track your progress.


“If you can erase your debts in a Chapter 7 bankruptcy, that’s a much better option than trying to negotiate settlements,” says NerdWallet columnist Liz Weston, author of “Your Credit Score” and “Deal With Your Debt.” “Only if Chapter 7 isn’t an option — you refuse to file for bankruptcy, or you can only qualify for a Chapter 13 repayment plan — should you consider debt settlement.”

How debt settlement works

Alternatives to debt settlement

DIY vs. using a debt settlement company

If you decide to try settlement

How debt settlement works

Debt settlement aims to reduce what you owe, mostly on unsecured debt such as credit cards. It’s not an option for certain types of debt, such as a house that can be foreclosed on or a car that can be repossessed. It’s also not for student loans (but an income-based repayment plan might help you).

Settlement offers work only if the alternative appears to be that you won’t pay at all.

There are three ways to approach it:

Debt settlement companies: You generally stop making payments on your outstanding debts and instead pay a debt settlement company, which deposits the money into a dedicated account. Once the company believes there is enough for a lump-sum offer to be considered, they negotiate it on your behalf.

By law, they can’t charge you upfront fees. You pay the debt settlement agency either a percentage of your total debt or a percentage of the debt eliminated by the settlement.

For example, say you owe $10,000. If the agency charges 15% of total debt, you would pay the agency $1,500 regardless of how the debt is settled. But if the agency charges 25% of eliminated debt, and it’s able to get your $10,000 balance reduced to a $6,000 lump sum, you’ll pay $1,000 in fees (25% of the $4,000 in eliminated debt).

Debt settlement lawyer: Most people hire debt settlement companies, but some use a debt settlement lawyer. A lawyer may bill by the hour, have a flat fee per creditor, or charge a percentage of debt or debt eliminated.

Do it yourself: Once you’re significantly behind, it usually doesn’t hurt to reach out to your creditor. Some banks have hardship programs that may be able to help. But be certain you can afford any reduced payment options your bank may offer.

If you want to try negotiating a settlement yourself, educate yourself on what’s likely to happen. You may want to gather as much cash as you can to make a lump-sum offer, whether this means taking a part-time job, selling sports equipment that’s been languishing in the basement or borrowing money from your cousin. (Creditors may be likelier to take a lump-sum offer, which gives them money immediately, rather than taking a chance on payments that might not come.)

Be honest about why you can’t pay, advises Michael Bovee, a debt settlement coach. The greater your hardship, the lower a creditor may go with a settlement. But if a creditor sees on your credit reports (and yes, it can see your credit reports) that you are managing to keep other loans and credit cards current, it’s less likely it will cut you much slack.

Alternatives to debt settlement

Bovee, a frequent critic of his industry (he has testified before the Federal Trade Commission in favor of more regulation), advises erasing your debt through Chapter 7 bankruptcy and starting again, if you have the option.

For borrowers who are overwhelmed by unsecured debt such as credit cards, a Chapter 7 bankruptcy is almost always a better option. Yes, a bankruptcy will sully your credit history for years, but the rebuilding process can begin immediately. Consultations with a bankruptcy attorney are typically free, though you’ll pay legal and filing fees if you choose this route.

If you don’t qualify for a bankruptcy or don’t want to file one, consider a debt management plan offered through a nonprofit credit counselor. Going that route will not typically reduce the amount you must repay, but it may reduce your monthly payments by stretching them out or by reducing your interest rate. It will have less impact on your credit than either bankruptcy or a debt settlement.

DIY vs. using a debt settlement company

Bovee generally advises the DIY approach for those who want to try debt settlement, but there are certain kinds of people he thinks are better off letting someone negotiate on their behalf. He says you shouldn’t try the negotiations yourself if you are:

  • Reactive, likely to respond emotionally.
  • Meek, hesitant to be assertive.
  • Unwilling to put in the time and effort to educate yourself about how the negotiating process works.

If you do decide to enlist the services of a debt settlement professional, be careful. It’s easy to let your guard down when you’re feeling desperate and see promises of debt relief. The National Consumer Law Center has said debt settlement companies are “almost never worthwhile and can get consumers into even deeper financial trouble.”

The Consumer Financial Protection Bureau takes a somewhat softer view, but still cautions consumers strongly, saying that dealing with such companies is risky and that other options should be explored first.

You should also be aware that the Internal Revenue Service generally regards forgiven debt as income. You may want to consult a tax professional about additional tax obligations you’ll be taking on if you settle your debt.

If you decide to try settlement

If you feel that debt settlement is the best or most appropriate choice for you and you want some assistance in pursuing debt settlement, Bovee has tips for choosing a company wisely:

  • Check with the Better Business Bureau to see if there’s a history of complaints.
  • Stay away from any company that seeks money in advance or guarantees that your debt can be settled.
  • Make sure fees are structured as a percentage of debt eliminated rather than of total debt; that gives the company incentive to trim more of your debt.
  • Avoid companies that promise to help you challenge debts to have them declared “invalid” (a tactic that can backfire and result in more aggressive action against you).

Bev O’Shea is a staff writer at NerdWallet, a personal finance website. Email: Twitter: @BeverlyOShea.

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