If you’re struggling with consumer debt and can’t seem to dig your way out, you’re not alone. In fact, you are one of many millions of Americans who deal with debt and its consequences in any given year.
Fact: The average adult with a credit card carried $6,348 in debt, paying an average APR of 15.54%. So far in 2018, we have also paid $104 billion in credit card interest and fees, which is 35% more than Americans paid five years ago.
With these figures in mind, it’s no wonder so many of us continue to fall further and further behind.
The painful reality is that 70 million Americans were contacted about a debt in collections in 2017, which typically means their debt was in default for at least 180 days. Debt collectors call consumers to follow up on these debts over one billion times per year, with up to 15 calls made per account per day.
While consumers can sometimes figure out a way to pay debt off on their own, there are strategies that can expedite the process. Some opt to consolidate their debts with a new loan that offers better terms and a lower interest rate, for example. Others sign up for a debt management plan, which is a debt repayment plan operated by a third-party credit counselor.
Finally, some consumers opt to negotiate their debts down through a process known as debt settlement. This option comes with its own share of pros and cons, and risks for consumers.
Before you decide to settle your debts, understand how it works, what the consequences might be and who can help you manage the process. This guide was created to explain your options and offer all the information you’ll need to decide for or against debt settlement.
What is debt settlement?
Unlike debt management plans, which are often offered by nonprofit companies, debt settlement programs tend to be administered by for-profit organizations. With debt settlement, the company you work with aims to negotiate a “settlement” with your creditors that is less than the amount you owe.
Since you’re already behind on your debts before you begin this type of plan, the debt settlement company asks you to save a specific sum of cash each month in a dedicated savings account. You do maintain ownership over the funds you save as well as any interest that accrues in your account, though. Your debt settlement company may ask you to stop making payments on your debts during the negotiation process, resulting in you purposely putting yourself further in default.
The end goal of these programs is that once a settlement amount is reached, you would have saved enough cash to pay the lowered amount in full. Once the final lump sum payment is made, the accounts are considered satisfied.
While debt settlement is an imperfect solution to a complex problem, this strategy could be the best option for you. Here’s how you can decide if it’s right for you:
- Determine the severity of your debt problems. According to Kevin Gallegos, vice president of client enrollment for Freedom Debt Relief, it’s important to make an honest assessment of whether you can pay down credit card balances and other debt on your own. Gallegos said that some people can use careful budgeting and belt-tightening or the debt snowball method to pay down debt without third-party help. Your first step should be figuring out how much you earn and comparing it with how much you owe on various debts each month. Look for ways to cut your budget and spending to free up cash you can use to repay your debts.
- Ask yourself if another option could bring a better result. Take a close look at alternatives such as debt consolidation and debt management plans. Each plan has pros and cons (which are discussed below), so take the time to explore these options and how they might work in your situation.
- Look closely at debt settlement if your situation warrants it. Gallegos said that generally speaking, debt settlement is a viable option for consumers who have significant debt ($7,500 or more) they can’t keep up with due to financial hardship.
When you should consider alternatives
While debt settlement can wipe away some of your debts if you’re struggling to keep up with minimum payments, there are times when you should look more closely at potential alternatives. Those instances can include:
- The debts you’re struggling to repay are secured debts. Debt settlement is only an option for unsecured debts — or debts that are not secured by collateral. With that in mind, debt settlement won’t fix all your problems if you’re struggling to repay secured debts such as car loans, your mortgage, home equity loans or federal student loans.
- You want to keep your credit score in good shape. Because debt settlement usually requires you to stop making payments on your debts until a settlement is reached, it’s likely your score will drop significantly as you move through the process. “If someone wants to protect credit scores more than put debt behind them, other options may be better,” said Gallegos.
How to settle your debts
Here are the main ways consumers can settle their debts by working with a third party or handling negotiations on their own.
Working directly with the debt collection agency
Mike Sullivan, a personal finance consultant with Take Charge America, a national nonprofit credit counseling and debt management agency that does not offer debt settlement services, said that consumers settling their own debts with collections agencies is very rare. This is partly because the process is complex, but also because it takes so long.
Still, here are the steps you need to take if you prefer to settle your debts on your own.
- Determine exactly how much you owe and make a list of all your credits and debt balances. You may also want to create a new spreadsheet or document so you can keep track of all your communications.
- Make a written offer to each creditor. Generally speaking, debt settlement requires you to make a specific written offer to each creditor. While there is no cut-and-dried amount creditors will take, you can often negotiate debts down to less than half of the balance you owe. However, creditors may not reply to offers for 60 to 90 days or even more than that after you’ve missed a payment.
- Continue making written counteroffers until an agreement is reached. Once again, this back-and-forth process can take many months. Once you have agreed with each creditor on an amount to be repaid, make sure you receive this agreement in writing.
- Be prepared to have funds available for a lump-sum settlement. Gallegos noted that if you owe a creditor $10,000 and they confirm they are willing to accept 50% of that amount, you must have the cash available immediately. “You will have to come up with $5,000, or the deal is off the table,” he said.
- Pay your settlement and demand a letter noting your debt has been satisfied. Make sure to get a letter from each creditor noting your payment and the satisfaction of your debts. This letter should be signed by an authorized agent of the creditor and share details of your settlement as well as wording that notes you no longer owe anything on debts associated with the account.
Working with a debt settlement company
Working with an agency that offers debt settlement is an easier proposition for many consumers since the debt settlement firm will perform most of the steps involved on your behalf. However, you’ll need to do some research and legwork upfront. The main steps required to work with a debt settlement company include:
- Research different debt settlement companies. Gallegos said that it’s a good idea for consumers considering debt settlement to do plenty of research and talk with a few different companies to see how they work. Make sure to confirm the company you work with offers individualized plans that are tailored to your needs, he said. Also, find out how long the company has been in business, any statistics about their success rate and how good their reviews are. Gallegos said that the American Fair Credit Council is a good resource to use when evaluating debt settlement companies.
- Watch out for companies with unethical practices. The Federal Trade Commission (FTC) said to avoid debt settlement companies that ask for money upfront, pressure you, makes guarantees about how your debts will be handled or don’t go over your financial situation in detail.
- Compare debt settlement fees. While debt settlement companies are prohibited by law to charge upfront fees for their services, they do charge a percentage of the enrolled debt amount — usually 18% to 25%. Make sure to compare companies and their fees before you move forward.
- Sign up for debt settlement. If you decide this is a viable option for you, you will need to sign a debt settlement contract. Once you are under contract, your debt settlement company will begin contacting your creditors on your behalf. You may be asked to stop making payments toward your debts during this time, which can hurt your credit score.
- Start saving money. Your debt settlement company will ask you to start saving a set amount of money in a separate bank account during the negotiation process.
- Reach a settlement with your creditors. If your debt settlement company can reach a settlement with creditors, the cash you’ve saved will be used to settle your remaining debts. At this point, your accounts will be considered charged off or satisfied, although you will likely have considerable damage to your credit score at this point. Keep in mind that the entire process can take 36 months or longer.
Debt settlement: Pros and cons to consider
While negotiating a settlement that is less than what you owe might sound advantageous, and it can be, debt settlement comes with both pros and cons. Here are the main advantages and disadvantages of this strategy:
Advantages of debt settlement:
- Repay less than you owe on your debts including the current principal, interest and fees. The main benefit of debt settlement is that if it works, you will pay less than you owe to have your debts settled and gone for good.
- Pay one monthly payment instead of several. Debt settlement lets you go from juggling several monthly payments to making a single payment toward your “savings” for future debt settlement each month.
- You won’t pay fees for debts that can’t be settled. According to the FTC, debt settlement companies can only charge you fees on debts they’ve successfully negotiated down and settled on your behalf. This means you won’t be charged fees on debts they weren’t able to settle.
- If you work with a debt settlement company, they will take care of many of the tasks involved in this process for you. Debt settlement companies do charge fees, but they will make phone calls, negotiate with creditors and deal with the details of your debt settlement on your behalf.
Disadvantages of debt settlement:
- Not all debts qualify for debt settlement. While most types of unsecured debt can qualify for debt settlement, secured debts like your mortgage, car loan and federal student loans do not. Many other types of debt such as child support, gambling debts and back taxes do not qualify.
- Debt settlement can result in damage to your credit score that takes years to fix. Because you’re typically asked to stop making payments on your debt during debt settlement, you will likely see damage to your credit score. However, Gallegos said that consumers typically see their scores bounce back once their debts are settled and they begin paying them off.
- Debt settlement may result in tax consequences. Some settled debts may be considered income and taxable as a result unless you are considered “insolvent.” The FTC notes that insolvency typically describes a situation where your total debts are worth more than your assets. This may sound clear-cut, but they report that insolvency is difficult to determine and prove.
- Debt settlement isn’t free. As we noted already, debt settlement costs money. You are typically charged 18% to 25% of each debt handled by a debt settlement company.
- Creditors are not required to settle with you. Creditors are under no obligation to settle your debts. For that reason, there’s a chance you could go through all the steps required for debt settlement only to end up without any resolution to your problem. The FTC also points out that debt settlement companies may try to negotiate smaller debts first, while interest and fees on large debts continue to grow. This could leave you worse off than when you began the process.
- Debt collectors may continue pursuing you. According to the FTC, creditors and debt collectors may continue to hound you for payment during the process. You could even be sued for repayment — even if you’re saving up money to settle your debts. If you are sued and you lose, your creditors could garnish your wages or even put a lien against your home.
What happens when you settle your debt
If you can move through the debt settlement process successfully and put all your debts behind you, the time and energy spent could be worth it despite the potential downsides. Why? Because your debts could go away for good, granting you a chance at a fresh start to rebuild your finances.
As we noted already, you may find you are liable for income taxes on some of your forgiven debts. You should also be aware that your credit score may have taken a significant hit that will take months or years to recover from.
Make sure to get a copy of a debt settlement letter from each of your creditors so you’ll have proof of the settlement and your payment if they try to collect in the future. Once you have this proof, you should also check your credit report to ensure settled debts are reported as “paid off.”
Alternatives to debt settlement
While the information we’ve offered on debt settlement may have you excited about the prospect, you may also be worried about the long-term consequences. Perhaps you want to keep your credit score in good shape while you get out of debt, or maybe you don’t like the idea of escaping full repayment of the debts you owe.
In any case, there are several alternatives to debt settlement you can consider. Your options include:
Debt management plan
Debt management plans are debt repayment plans administered by third-party credit counselors who work for nonprofit agencies. These credit counselors call your creditors and negotiate more favorable terms on your behalf, including lower interest rates and reduced or waived fees. Once creditors agree to these concessions, consumers begin making a single monthly payment to the nonprofit agency overseeing their debt management plan. The nonprofit agency then distributes funds to their creditors on their behalf, taking care of the grunt work for them.
Debt management plans can take up to 48 months or longer to complete. Consumers are also asked to stop using credit cards and get on a budget or spending plan during the process. Ultimately, the goal of debt management plans is helping consumers escape high interest and fees, pay down their debt over time and learn positive money habits along the way.
- Nonprofit credit counseling agencies will work on your behalf to negotiate lower interest rates and reduced or waived fees.
- You may be able to preserve your credit score since you continue making payments all along, albeit through the nonprofit agency that administers your plan.
- Debt management plans typically cost only $25 to $35 per month, whereas debt settlement can cost you 18% to 25% of your debts.
- There is usually an educational component to complete with debt management plans, which could mean you’ll get better at budgeting and cash flow management.
- Debt management plans can take 48 months or longer to complete.
- Debt management plans may be affordable, but you still have to pay for the help you receive.
- You will ultimately pay back all the money you borrowed, whereas debt settlement lets you pay less than you owe.
Debt consolidation is another option to consider if you are financially unable to repay your debts. With debt consolidation, you will replace your existing loans with a new loan with better terms and a lower interest rate. The goals of debt consolidation can include lowering your monthly payment, saving money on interest and simplifying your finances with a single loan instead of several.
- You may be able to qualify for a new loan with a lower interest rate and better terms. Some 0% APR credit cards also let you transfer balances to secure zero interest for anywhere from 12 to 21 months (balance transfer fees may apply).
- Debt consolidation lets you handle and repay your debts without third-party oversight.
- You may not be able to qualify for personal loans or 0% APR cards with excellent terms if your credit score is in bad shape. Typically, the best loans and terms go to those with FICO scores of 740 or higher.
- It takes a lot of discipline to pay off debt without any outside help. This makes this strategy difficult to execute if you’re already struggling.
- Many debt consolidation loans, including home equity loans, personal loans and 0% balance transfer cards come with fees you have to pay to use them.
Bankruptcy is another last resort option to consider if you have considerable amounts of debt you can’t seem to handle on your own. However, it’s important to note there are two main types of bankruptcy to consider:
- Chapter 7 bankruptcy may allow total discharge of your debts outside of other debts such as child support and back taxes. However, you may be required to sell assets to settle some of the amounts you owe.
- Chapter 13 bankruptcy restructures your debt with a repayment plan instead of discharging your debts. You typically repay your debts over three to five years with this process, and you do not have to sell a property to settle amounts you owe.
Advantages and disadvantages of bankruptcy include:
- Discharge or restructure your debts depending on the bankruptcy option you choose.
- Once your bankruptcy is complete, you can get a fresh start.
- Certain assets such as your home, car, and retirement accounts are protected up to certain limits with Chapter 7 bankruptcy, so it’s possible you won’t lose everything in the process.
- There are requirements to qualify for Chapter 7 or Chapter 13 bankruptcy, meaning not everyone can access this option.
- Chapter 13 bankruptcy stays on your credit report for seven years after you file, while Chapter 7 bankruptcy stays on your report for ten years.
- Bankruptcy isn’t free since you will likely need to hire an attorney to walk you through the process. You must also receive credit counseling from a government-approved organization within six months before you file for bankruptcy, notes the FTC.
Frequently Asked Questions (FAQs)
As you continue researching ways to pay off your debt for good, it helps to educate yourself on debt settlement and its alternatives. This list of frequently asked questions could help you with your decision.
The FTC states that debt settlement companies are required to disclose certain information upfront such as the fees they charge, how long it will take to get results, how much you need to save before they can settle your debts and the consequences you will face when you stop making payments to your creditors. You should also be notified that the money you save — including interest — is yours and that the account you use for savings is not affiliated with the debt settlement company. You also have the right to withdraw your funds at any time for any reason without penalty.
Fees charged by debt settlement companies can vary based on how many of your debts they settle and the percentage they agree to charge upfront. However, many debt settlement companies charge 18% to 25% of their debts handled through the program. This could add up to thousands of dollars in fees once the program is complete.
Because debt settlement companies ask you to stop making payments on your debts and save up to settle them instead, your credit score will take a hit. Considering that your payment history makes up 35% of your FICO score, it should be no surprise that letting all your accounts go into default would damage your credit score.
While the answer is different for everyone, debt settlement is best for consumers with considerable unsecured debts they can’t seem to pay off on their own. These programs are often the last resort for consumers who struggle to keep up with minimum monthly payments and know they need help from a third party to avoid bankruptcy.
Debt settlement can take 36 months or longer to complete depending on how much debt you owe, how long your creditors take to negotiate and how long it takes you to save up the money you need to settle. Longer timelines are typically reserved for individuals with considerable debt and many creditors.
While you can settle your debts on your own, it’s not very common. Not only will you need to communicate back and forth with each creditor for many months, but you’ll have to negotiate with them to repay less than you owe. Many consumers don’t have the knowledge or confidence to negotiate on their own behalf, so they turn to debt settlement companies or nonprofit credit counseling agencies for help.
Typically, unsecured debts qualify for debt settlement. This can include credit card debt, unsecured personal loans, some private student loan debt, medical bills, auto repossessions, cell phone and utility bills from past providers and department and store charge card debt.
Debts that don’t work with debt settlement typically include secured debts. Common debts that don’t qualify are car loans, mortgage loans, federal student loans, utility bills from current providers, overdue taxes, gambling debts and debts resulting from lawsuits.
Debt consolidation involves getting a new loan with a lower interest rate and better terms with the goal of combining old, higher interest debts into a single new debt. Common financial products used in debt consolidation include personal loans, home equity loans, home equity lines of credit (HELOCs) and balance transfer credit cards.
Debt settlement is a long-term process that involves having a third-party debt settlement company settle debts on your behalf while you save the cash for your settlement instead of making payments on your debts. With debt settlement, you may be able to repay less than the amounts you owe.
A debt management plan is a third-party debt repayment plan that is typically administered by a nonprofit credit counseling agency. With a debt management plan, the credit counseling agency will negotiate with your creditors to lower your interest rate and remove late fees or over-the-limit fees from your account. During the program, you’ll make a single monthly payment to the nonprofit credit counseling agency who will disburse the funds on your behalf.
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