It’s alarming how easy it is to get in over your head with debt. Like a snowball rolling downhill, mortgages, loans, credit cards, and medical bills can quickly become a mountain of debt you can’t pay. The next thing you know, debt collectors are beating down your door.
A debt settlement program can help you escape. Creditors are often willing to settle for a lower sum than you owe rather than risk having to write it off as a complete loss. You can either negotiate your own debt settlement or work with a company like Freedom Debt Relief.
Large companies have small armies of accountants helping them decide when accepting a settlement is smart. But individual debtors don’t have the same resources. You have to do the math yourself to decide whether settlement is the best solution to your debt problems.
How Debt Settlement Works
In a debt settlement, you agree to pay your creditors an amount less than what you owe. In most cases, you must pay this amount as a lump sum. In exchange, they agree to cancel the rest of the debt and can’t sue you for it or send debt collectors after you.
At first glance, it’s not obvious why creditors would accept a debt settlement. Why would they settle for $20,000 on a $40,000 debt?
If they think you can’t pay it off, there are several reasons settling is a better option than holding out.
- Suing you is costly and time-consuming and may not work.
- You could declare Chapter 7 or Chapter 13 bankruptcy, and if they hold unsecured debts (those not backed by collateral, such as credit card or medical debt), those debts would likely be canceled anyway.
- If they’re a debt collector, they probably paid pennies on the dollar for the debt, so they don’t need to collect the full amount to make a profit.
Disadvantages of Debt Settlement
The obvious benefit of debt settlement is getting rid of debt for less than you owe. Many creditors will settle a debt for less than half the original amount. And if you can make a smaller lump-sum payment upfront, you can become debt-free much faster than with years of monthly payments.
However, debt settlement also has significant downsides. Before jumping at this chance to be free from your debt, you need to be aware of the consequences.
1. Damaged Credit
The primary downside of negotiating with your creditors is that it can further damage your credit score. But that’s probably already suffering due to all the missed payments.
Creditors are only willing to negotiate if they believe you’re not going to pay them back. To get them to take you seriously, you must skip payments while you’re negotiating.
Each missed payment is another blow to your credit score, and there’s no guarantee you can obtain a settlement in the end. And even if your creditors agree to a settlement, the damage to your credit isn’t over. A debt listed as “settled” is a serious black mark on your credit report that lasts for seven years.
But it’s often less damaging than the alternatives. Bankruptcy hurts your credit even more, and so does leaving the account open with a balance that’s past due. Also, leaving the debt unpaid could lead to other detrimental actions from your creditor, such as:
- A charge-off (having the debt marked as unlikely to be repaid, usually when it’s six months overdue)
- Having the debt sent to collections
- Taking you to court and getting a judgment against you, which could result in having your wages or assets garnished (seized)
Negotiating with creditors also offers a way to soften the blow to your credit. You can negotiate how much you pay and how they report your settled debt to the credit bureaus. If you can persuade them to mark the account “paid as agreed,” it hurts your credit score less than a debt marked as “settled” or “paid settled.”
2. Additional Taxes
When you settle a debt, the IRS can treat that forgiven debt as taxable income. In general, you must pay taxes on any canceled debt of $600 or more.
If the amount of the forgiven debt is in the tens of thousands, that can lead to a sizable bump in your next tax bill.
3. A Long Wait
Debt settlement can also take a long time. You have to accumulate enough money to offer a lump-sum payment to your creditors.
Many debt-settlement companies require you to make payments into a special account for at least 36 months (three years) before you can settle all your debt. According to the Federal Trade Commission, many people drop out of the program before the three years are up. DIY debt settlement can be faster, but it’s still a lengthy process.
4. High Fees
If you use a debt settlement company, there’s the fee to consider.
Most debt settlement companies charge a fee between 15% and 25% of your debt — either the settled amount or the total amount. That means if you settle $10,000 in debt for $5,000, the fee could be anywhere from $750 to $2,500.
When Debt Settlement Might Be a Good Idea
Although settling debt hurts your credit in the short term, it is often the best way to get your finances back on track. However, there are other worthy alternatives for getting out of debt.
If you can figure out a way to do it, paying off your debt in full is always the best option. Often a debt consolidation loan or credit counseling can help. And if your situation is desperate, bankruptcy could be the easiest way to break free from your debt and start over.
To figure out whether debt settlement is the best option for you, assess your situation. Several factors could make debt settlement the best choice for you.
You Have Negotiable Debts
Creditors are more willing to negotiate some types of debt than others. In general, they’re more prepared to settle a debt if they think they can get more of their money back with less hassle than they would by holding out for the whole amount.
Debts that creditors are usually willing to negotiate include:
- Credit Card Debt. Your credit card balance is one of the easiest types of debt to negotiate. Credit card companies are usually willing to bargain because they’ll probably get nothing if you file bankruptcy.
- Unsecured Bank Loans. Most banks would rather settle than risk losing everything on unsecured debt. But credit unions can use collateral from other debts like auto loans to secure a different loan. Even if you’ve paid off the first loan, they can still repossess your collateral. That makes them less likely to settle for less than half.
- Unpaid Bills. Unpaid bills, such as medical bills, are basically unsecured loans. Bankruptcy usually wipes them out, which gives creditors a strong incentive to negotiate.
You Don’t Have Nonnegotiable Debt
Other types of debt are much harder to negotiate. If the bulk of your debt is one of these types, it will be harder to settle. They include:
- Secured Loans. Secured loans are backed by assets like a car or home. The lender can repossess them if you don’t pay. Thus, they have little reason to negotiate. However, small local lenders are more likely to negotiate. And you can sometimes negotiate lower payments or more time on a car loan.
- Federal Student Loans. You usually can’t get federal student loans discharged through bankruptcy, and they have strict repayment rules. Thus, creditors don’t have a reason to negotiate. However, it’s easier to negotiate private student loans.
- Unpaid Federal Taxes. If you owe federal back taxes, especially older debt, the IRS can offer a monthly payment plan. You may also be able to make an offer in compromise, a smaller amount as a lump sum. But these are hard to get approved.
- Mortgage Debt. If you fall behind on your mortgage payments, your lender can foreclose on your home to recover the balance. That gives them less incentive to settle. But foreclosure is a hassle for lenders, so there’s a good chance the bank will work with you to avoid it.
Your Debt Is Several Months Past Due
Most lenders only consider a debt settlement for a debt that’s over 90 days past due. And once your debt is four to six months late, there’s a good chance the creditor will offer you a settlement.
That’s because creditors generally give up on collecting any debt past this point.
Instead, they charge it off. They remove it from their books and pass it on to a collection agency or debt buyer, and they get nothing. So the closer you get to this crucial six-month mark, the better your chances of getting the bulk of your debt canceled.
However, there are downsides to waiting that long before asking for a debt settlement. You have to continue skipping payments while you negotiate, causing your credit score to drop even lower, and there’s no guarantee you’ll succeed in reducing the debt.
Also, the longer you wait past the 90-day mark, the greater the risk your debt ends up in collections. That’s an even more serious blow to your credit score.
Your best bet is probably to start negotiating with the creditor as soon as your debt is 90 days overdue. The sooner you start working on the problem, the better the chances you can minimize the damage to your credit rating.
You Have Money for a Settlement
If you want to make a deal to settle your debt, it pays to have the money to back it up. Creditors are more likely to agree to a deal if you offer them a large lump-sum payment rather than a series of smaller ones. Since you’ve already missed existing payments, they have reason to worry you won’t make payments on the new plan either.
Possible ways to get a large enough lump sum for debt settlement include:
- Raiding your emergency fund
- Using the cash from a financial windfall, such as an inheritance, lottery winnings, or a sizable tax refund
- Taking an early withdrawal from your retirement account if the penalty is less than the amount you save by reducing your debt
If you can’t come up with a sufficient lump sum, you can try to talk your creditors into a payment plan. You’ll most likely pay more in total that way, but the individual payments could be easier to handle. If you agree to a payment plan for debt settlement, ensure you understand how much you’ll pay overall.
You’re a Good Negotiator
Settling a debt for significantly less than you owe requires adept negotiating skills. To a large extent, it’s a matter of self-confidence. If you believe you can strike a good bargain, you probably can.
Practicing your sales pitch in advance can help you feel more confident when you make the call. If necessary, enlist the help of a friend.
If you’re still uncertain about your ability to negotiate when so much is at stake, look for professional help. A credit counseling agency might have more luck talking your creditors into a repayment plan than you can on your own.
And if debt collectors are giving you a hard time, talk to a lawyer. Most bankruptcy attorneys offer a free initial consultation, and they can advise you about what creditors can and can’t legally do to collect on a debt.
Debt settlement isn’t a quick or easy solution to debt problems. It’s a lengthy process that can take months or even years to get through. And even when the debt is gone, you still have to deal with tax on the forgiven debt and repairing the damage to your credit score.
But in many cases, debt settlement is better than the alternatives. Although it’s a blow to your credit, it’s not as harmful as a bankruptcy. And if your debts are too big to pay off any other way, settling them gives you a chance to get the debt burden off your back once and for all.