Debt settlement. I’ve heard this term over and over in recent months. While I’ve had a vague idea of what this means, I’ve never known exactly what debt settlement entails, so today I thought I’d take a closer look.
Debt settlement in a nutshell
Debt settlement involves negotiating with a creditor to agree on a reduced balance that will be accepted as payment in full. In short, if you fall behind on your payments, your lender(s) might be willing to cut a deal to get at least a portion of their money back in a lump sum payment.
Debt settlement is typically only an option for unsecured debt, such as credit cards, and lenders usually won’t even broach the subject unless you’re already behind on your payments. If that’s you, then debt settlement might be a viable option.
How to settle a debt
While individual consumers can settle a debt on their own, or use an attorney acting on their behalf, debt settlement companies have become increasingly common in recent years. If you’re interested in settling a debt yourself, and you’ve saved up a lump sum to offer as a payoff, then you can contact the lender and try to cut a deal yourself.
Many consumers who opt for debt settlement don’t have a lump sum of cash on hand. In such cases, debt settlement companies will set up an account to receive deposits on the consumer’s behalf such that they can build up the necessary lump sum. Once the consumer has enough funds on hand, the settlement process can begin.
The debt settlement company will contact individual creditors and work to negotiate a reduced payoff. The incentive to the creditor is that they’ll received at least a portion of what is owed rather than having to engage an external collections company, or losing out in a bankruptcy filing.
The downside here is that debt settlement companies charge exorbitant fees for their service. In most cases, this is charged either as a percentage of your total debt (i.e., the more debt you have, the more they charge), or as a percentage of amount of debt forgiven (i.e., the more you save, the more they charge).
The dangers of debt settlement
As always, there is no such thing as a free lunch. Aside from the possibility of fraud on behalf of the debt settlement company, here are some possible downsides to debt settlement:
- Credit score effects. Not surprisingly, debt settlement will have a negative impact on your credit score.
- Income tax consequences. While a debt settlement can save you a good amount of money, the portion of your debt that is written off will need to be reported as taxable income.
- Lawsuits. When they first get contacted by the settlement company, your creditor (or their collection agent) might immediately sue for the amounts owed.
- Legal considerations. Twelve states actually have laws banning for-profit debt management, meaning that the services of debt settlement companies might not be legally available where you live.
Debt settlement stories?
If you’ve ever been through the debt settlement process, or know someone who has, please share what you’ve learned in the comments section.