An estimated 1.82 percent of credit card holders were delinquent on their debt in the fourth quarter of 2017, according to TransUnion. If you’re one of the cardholders struggling with bills, debt settlement could help with getting your financial situation under control.
Debt settlement involves negotiating with creditors to pay back less than you owe on outstanding debts. Third parties — such as debt settlement companies — often facilitate debt settlement and act as go-betweens and negotiate with creditors on your behalf, as the FTC explains. However, you don’t have to work with anyone for debt settlement negotiations. You can talk with creditors on your own and get a deal in writing to resolve an outstanding debt balance.
Whichever approach you choose, there are both pros and cons to settling your debt. Because of the downsides, this approach should often be considered a last resort — but it is an option to consider under the right circumstances.
What is debt settlement?
When you settle debt, you offer to pay less than the outstanding balance if the creditor will accept your payment as satisfaction of the debt.
A settlement agreement reached with a creditor may require you make a lump sum payment or negotiate a payment plan. For example, if you owe $1,000, you could offer a $600 payment if the creditor agrees not to try and collect the $400 remaining balance.
When you negotiate an agreement, base your offer on what you can afford. You could calculate this by determining how much money you could pay each month, or by determining how much money you have available to make a lump sum payment.
Creditors agree to debt settlement if they fear you won’t otherwise pay back what you owe — perhaps because of a bankruptcy filing — or if it would cost them too much to try to collect. Debtors benefit because collection efforts stop, interest and late fees no longer continue accruing, and creditors stop posting repeated negatives on their credit report.
When is debt settlement the right choice?
Debt settlement can be a good option under certain circumstances. “When it is done right it can save a lot of money,” said Robertson Cohen, a Colorado debt settlement and bankruptcy lawyer at Cohen & Cohen, P.C.
To decide if debt settlement is a good choice, the Consumer Financial Protection Bureau recommends first learning about the debt. If the debt is old, it may be outside the statute of limitations and no longer collectible. If you don’t believe you owe the debt, you can require the creditor to prove the balance due and the right to collect.
If you do owe and the statute of limitations has not run out, you’ll need to make sure settlement is affordable. Calculate the amount of discretionary income you have by subtracting monthly expenses from take-home pay, and providing a cushion for emergencies. If you have enough money left to make payments towards settling your debt and your creditor is willing to accept a proposed repayment plan during debt settlement negotiations, settling is a viable option.
As part of the terms of the settlement, the creditor should agree to stop collection efforts and forgive the remaining debt balance once you have completed the payment plan. CFPB advised that you get these promises in writing before you make a payment.
Advantages of debt settlement
Debt settlement could allow you to reduce the balance due on the outstanding debt dramatically. The Better Business Bureau indicates creditors may reduce outstanding balances by around 40 to 60 percent of what was owed. As this chart shows, the savings could be substantial, depending upon your outstanding debt balance.
|Debt Balance||Amount Saved if You Settle for 60% of Debt Balance||Amount Saved if You Settle for 40% of Debt Balance|
Stopping efforts to collect is also beneficial, as you will no longer need to worry about collection calls, wage garnishment, or a creditor suing you in court for nonpayment of your debt.
Disadvantages of settling debt
There are some big downsides to debt settlement. “A few things come to mind right away,” Cohen said. “Tax consequences of forgiveness, damage to credit, shady outfits that disappear with your money, and the general uncertainty.”
Your credit score is inevitably damaged by debt settlement because, as Cohen explained, creditors have no incentive to settle when you’re current on your debt. “At minimum, you are going to have to go delinquent before they will even consider it.”
The impact of debt settlement on your credit score varies depending on where your score was before settling debt. According to MyFico, a debtor with a credit score of 780 would see a drop to around 655 to 675 after settling a credit card debt, while a debtor with a score of 680 would end up with a score of around 615 to 635 after settlement.
Some creditors are also unwilling to settle and will instead charge off debt and send you to collections — leaving you to work with the debt buyer. “Lates and charge-offs are not known for their credit score enhancing properties,” said Cohen.
The tax consequences of forgiveness could include a significant IRS bill, according to MarketWatch. Money saved by settling debt is treated as income. If a creditor forgives $500 worth of unpaid debt, you’ll owe the IRS income tax on the forgiven $500.
Shady outfits are another big problem in the debt collection industry. Cohen warned that just because a debt settlement company claims to be a nonprofit doesn’t guarantee it’s a good company. Many nonprofits make advanced deals with banks to reduce rates for delinquent borrowers who come to the nonprofit for help — but there’s fine print, like requirements to deposit payments into a bank account for years without missing a single payment, and few complete the program. Those who don’t complete the payment plan end up owing even more than they did when they started. Banks collect a lot of money from debtors under these “agreements” and make tax-deductible donations to nonprofits who facilitated the transaction. The nonprofits pay staff well, donating excess to charities to maintain their nonprofit status.
Finally, general uncertainty comes from the fact creditors sometimes “re-age” settled debt. “When it shows up on your credit a few years later with a similar but different balance, with a new account number, and a few collectors down the food chain, guess whose burden it is to prove that it was settled?” Cohen said. “It’s a huge hassle and it coincidentally usually hits right when you have rebuilt your credit. Most people just ‘settle’ again because it’s easier.”
What are some alternatives to debt settlement negotiations?
Settling debt is not the only way to resolve your debt problems. There are alternatives, including:
- Refinancing debt. Refinancing debt changes the terms of your payment. You could refinance by taking a personal loan to pay off high credit card debt. Even taking a balance transfer on a credit card is a form of refinancing. Refinancing can make more sense if you can refinance to a new loan with a longer repayment period, a lower interest rate, or other terms that lower your payments to an affordable level.
- Consolidating debt. Consolidating your debt using the right consolidation method also changes the terms of your payment. When you consolidate, you take out one big loan to repay several others. For example, you could take out one personal loan to repay five credit card balances. Consolidating can lower your monthly payment and make your debt more manageable.
- Bankruptcy. While many view bankruptcy as a dire option, it may be better in certain circumstances than debt settlement. Cohen warned against taking drastic steps to settle debt, such as liquidating retirement funds or taking a home equity loan. Both retirement assets and home equity can be protected in bankruptcy, and you don’t want to convert unsecured debt that is dischargeable into secured debt that puts your home at risk.
What should you do?
Before you decide to settle debt, make sure you will be able to comply with the repayment terms. Cohen warns many people who opt for debt settlement actually cannot afford to complete repayment plans successfully. If you can’t pay what you agreed, you could end up wasting money trying to settle debt and then owing more when the agreement fails.
You should also consider if other alternatives are an affordable, viable solution for you. If you can qualify for a loan to consolidate or refinance debt and can afford the payments on the new loan, this is a much better option to protect your credit score.
Whatever you do, it’s key to make your choice with a focus on the big picture. “You have to look forward and ask yourself is this a long-term solution or just a temporary fix,” Cohen said. Creating a strategy to get all of your debt under control — and to stay debt free in the future — can give you peace of mind.
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