Debt Settlement: Is It the Most Economical Way to Get Out of Debt?
You may be able to save money and pay off debt more quickly.
Is a debt settlement program the cheapest route out of debt if you’re in debt and can’t pay your bills? The American Fair Credit Council (AFCC), an industry group of debt settlement businesses that have committed to a stringent code of conduct, can lead you to that conclusion.
Debt settlement delivered on average $2.64 in consumer savings for every $1.00 cost imposed, according to the 2020 report, and virtually all proposed settlements (over 98 percent) resulted in a reduction of the client’s debt that was more than the associated fees.
“Gerri Detweiler, co-author of the eBook Debt Collection Answers: How to Use Debt Collection Laws to Protect Your Rights, explains that debt settlement may save customers money by enabling them to settle their debts for less than the whole total. 2 “It may be a path out of debt for some people who can’t afford to pay back the whole amount they owe,” he says.
Is debt settlement, however, the most cost-effective approach to get out of debt? Let’s look at it more closely.
Key Takeaways
• Debt settlement is making a one-time payment to a creditor in return for the forgiveness of a part of your debt.
• It is critical to cease making minimal monthly payments on that debt in order to effectively negotiate a debt settlement plan, since this will result in late penalties and interest, as well as harm to your credit score.
• Typical debt settlement offers vary from 10% to 50% of your outstanding debt.
• The longer you wait to pay a debt, the more likely you are to be sued.
• Even if you deal with a respectable debt settlement organization, creditors are under no obligation to lower your debt.
What Is Debt Settlement and How Does It Work?
Debt settlement, often known as “debt relief” or “debt adjustment,” is a method of settling outstanding debt for a fraction of the original amount owed by guaranteeing the lender a large lump-sum payment. Debt settlement offers might vary from 10% to 50% of what you owe, depending on your circumstances. The creditor must next determine which, if any, offers to accept.
Consumers may either settle their debts on their own or employ a debt settlement service to do it on their behalf. In the latter situation, you’ll pay a percentage of your enrolled debt as a fee to the business. The amount of debt you have when you enroll in the program is referred to as enrolled debt. The firm is prohibited by law from charging this fee until your debt has been cleared. Fees range from 20% to 25% on average.
Taxes may be incurred as a result of debt settlement. The forgiven debt is considered taxable income by the Internal Revenue Service (IRS). You will not have to pay tax on your discharged debt if you can prove to the IRS that you are insolvent. If your entire obligations surpass your total assets, the IRS will consider you insolvent. To find out whether you qualify for insolvency, you should speak with a professional public accountant.
Debt settlement is by far the cheapest alternative compared to credit counseling or making minimum monthly payments, according to AFCC statistics compiled by Freedom Debt Relief, one of the country’s most famous debt negotiators, as seen in the infographic below.
Debt settlement may or may not be the most cost-effective choice for you, depending on the facts of your case. Your credit score will almost certainly suffer as a result of debt settlement.
Risks and Strategies for Debt Settlement
Consumers who engage in a debt settlement program because they can’t handle their financial obligations but have continued to make payments, even erratic ones, have less bargaining strength than those who haven’t. As a result, their first move must be to cease all payments. “During the debt settlement process, credit scores might suffer, especially in the beginning,” says Sean Fox, co-president of Freedom Debt Relief. “Credit scores often rebound over time as the client continues to make payments on resolved debt.”
Delinquent debt and settling for less than you owe may have a significant negative influence on your credit score, perhaps lowering it to the mid-500s, which is considered bad. The bigger the decline, the higher your score before you fall behind. Late payments may be reported to the credit bureaus for up to seven years.
If you don’t pay, you’ll accrue late penalties and interest, which will increase your amount and make it more difficult to pay off your debt if you can’t settle. Once a consumer becomes late, they may expect to receive harassing debt collection phone calls. Creditors may also choose to sue customers for debts over $5,000—debts that are worth their time and effort, in other words—resulting in wage garnishment. “The more money you have to satisfy the debt, the faster you can get out of it.” “The longer you go without paying your debt, the more likely you are to be sued,” Detweiler adds.
There are no assurances that the lender will agree to a settlement after you’ve suffered this harm, or that it would agree to settle the debt for as little as you’d anticipated. For example, Chase will not engage with debt settlement companies. It will only work with customers or nonprofit, accredited credit counseling organizations that assist them. The Consumer Financial Protection Bureau (CFPB) warns that if you don’t settle all or most of your obligations, the cumulative fines and fees on unpaid bills might wipe out whatever savings you get from a debt settlement business.
Bankruptcy vs. Debt Settlement
Debt settlement may be beneficial to all parties involved if the procedure is carried out correctly. Consumers get out of debt and save money, debt settlement companies make money for providing a vital service, and creditors get paid more than they would if the consumer stopped paying or filed for bankruptcy under Chapter 7. The debtor’s non-exempt assets are liquidated in Chapter 7 bankruptcy, and the profits are used to repay creditors. Household and personal belongings, a specific amount of home equity, retirement funds, and a car are all examples of exempt assets that differ by state.
“If a customer is qualified for chapter 7 bankruptcy, it may be a speedier choice than debt settlement,” Detweiler adds. It’s a legal procedure that may put an end to debt collection calls and litigation. These assurances are not provided by debt settlement.” “There may be a multitude of reasons why chapter 7 may not be a viable choice,” he says. A customer may be forced to give up property that they believe they need to maintain. Alternatively, they may not want their financial difficulties to be made public.” Consumers’ job possibilities may be restricted if they file for bankruptcy since several professions assess employees’ credit histories.
Another issue that many impoverished people encounter is the inability to afford bankruptcy counsel. According to Fox, “many customers do not qualify for bankruptcy protection.” “By contrast, debt settlement is open to any consumer who may establish a financial difficulty, such as a job loss, reduced hours worked, medical expenditure, a death in the family, divorce, or another similar event, and is struggling to pay off their debt.”
In comparison to debt settlement, Chapter 7 bankruptcy may be completed in three to six months. Although bankruptcy will stay on your credit record for ten years, it may be less stressful and may help your credit score to recover quicker.
Check to see whether debt settlement is something you can afford. Many debt settlement programs ask you to deposit a fixed amount of money into a designated savings account on a monthly basis for 36 months or longer. Before you sign up for a debt settlement program, be sure you can afford to put aside the appropriate funds for the duration of the program.
Minimum Monthly Payments vs. Debt Settlement
Consumers who wish to save money should avoid making minimum monthly payments on high-interest loans. Depending on how much debt you have and what your interest rate is, it might take years, if not decades. Interest accrues on your total sum every day, and with minimum payments, you make little progress in paying down your debt each month.
Making minimum monthly payments and paying a lot of interest to your creditors may make you very lucrative to them, and sure, a strong payment history is beneficial for your credit score. However, if you want to improve your credit score, we don’t advocate paying more in interest than you have to. Money in the bank, not a high credit score, will pay for your retirement.
Furthermore, if the amount of available credit you’ve utilized is disproportionately large in comparison to your credit line, your credit score will suffer, possibly negating the benefit of your regular, on-time payments. According to the AFCC study, “After costs were deducted, the typical customer lowered their overall debt from about $30,000 to $35,000 at the time of settlement.
Making just the minimum monthly payment on a high-interest credit card debt might result in paying more in interest than the principal.
Credit Counseling vs. Debt Settlement
Nonprofits and government entities provide credit counseling for free or at a low cost. Surprisingly, credit card companies often support these services in part. You may qualify for a lower interest rate on your debts and a waiver of penalty fees if you participate in a debt management plan with a credit counseling organization.
Those concessions may or may not be enough to help you pay off your debt more quickly, and you may or may not be able to afford the increased monthly payments. Furthermore, even if you have a considerable financial difficulty, you may not be eligible for an interest rate decrease.
Your credit score may suffer less as a result of not having to default on your obligation. Additionally, credit counseling may provide extra financial aid to help you prevent future difficulties, such as budgeting and financial counseling, as well as recommendations to low-cost services and assistance programs to help you save costs. A reputable debt settlement organization, according to Fox, would also work with customers to teach them how to budget, appropriately utilize credit, and live within their means.
So, if you don’t want to file for bankruptcy, how do you determine which path to take? “Credit counseling is best suited for individuals who have unsecured debt of $2,500 to $15,000 and merely need an interest rate decrease to make monthly payments affordable,” Fox adds.
“On the other side, debt settlement works effectively for those who have more than $15,000 in credit card debt and require a decrease in the real principle owing in order to make headway on their debt.” He goes on to say: “Credit counseling and consolidation loans are acceptable for clients who are experiencing less severe financial difficulties. Debt settlement and bankruptcy, on the other hand, benefit individuals who are under more severe financial strain.”
The Federal Trade Commission gives advice on how to find a credit counselor on their website. Another helpful resource is the National Foundation for Credit Counseling.
Frequently Asked Questions about Debt Settlement
In a settlement, what percentage of a debt is considered?
According to the Center for Responsible Lending, debts are resolved at a rate of 48 percent of the outstanding sum on average. However, the analysis indicated that the amount rises by 20% as a result of costs imposed by the creditor during debt settlement negotiations.
How Do You Handle Your Own Credit Card Debt Settlement?
The easiest strategy to negotiate a credit card debt settlement on your own is to contact your creditors and ask if you can be placed on a debt repayment plan. Depending on your circumstances, some creditors may be willing to work with you.
What Effect Does Debt Settlement Have on Your Credit Score?
A debt settlement will appear on your credit record for seven years after the delinquency date.
How Do You Locate a Reputable Debt Settlement Firm?
If you need a reputable debt settlement business, you may ask your friends and relatives for advice, consult your financial counselor, or read internet evaluations. Consumer Affairs magazine, for example, produces a trustworthy list, and the Federal Trade Commission (FTC) provides information on both credit counseling and debt settlement firms.
What is a Debt Settlement Scam, and how does it work?
Debt settlement schemes are unfortunately widespread. Scams may be perpetrated by for-profit firms offering to “remove your debt” for a large cost. These charlatans will usually demand a large sum of money in exchange for their services, but will accomplish little or nothing on your behalf. These businesses may claim to be able to “repair” or “erase” negative credit from your credit record, which is impossible.
Furthermore, a debt settlement scam may lead to you incurring even more debt if the firm claims to have contacted your creditors but fails to do so, leading you to assume your debt has been settled. Before joining up with a debt settlement company, always check with the Better Business Bureau or your state’s attorney general’s office online.
After a debt settlement, how can you get your credit back on track?
Debt settlement appears on your credit record for seven years, beginning with the date of your default. It’s critical to avoid going over your credit limit, pay your bills on time, and keep your debt-to-credit usage ratio in check if you want to rebuild your credit following a settlement.
Final Thoughts
For many people, debt settlement may be the most cost-effective method to get out of debt. It depends in part on how much money you owe, but there are other aspects to consider as well, like how long it takes and how stressful it is in comparison to the alternatives. Before you select debt settlement, be sure you grasp all of the benefits and drawbacks.
The best strategy is to look into all three possibilities. “Talk to a credit counseling agency, a debt settlement specialist, and a bankruptcy attorney if you’re in debt so you can understand your alternatives and make an educated decision,” says Detweiler.
