Debt settlement: Is it right for you?

It's a solution, but beware false promises and know the credit downsides

Dawn Papandrea
Personal Finance Writer
Specializes in family finances

 Debt Settlement: Is it Right for You?

If you’re drowning in debt and don’t want to or can’t qualify for bankruptcy, there is another option to look into: debt settlement. There’s nothing simple about the process, and it’s certainly not the ideal course of action for everyone, but under the right circumstances, it can give people the second chance they need.

Debt settlement involves negotiating with creditors to get them to reduce the full amount you owe by agreeing to pay a lump sum. Oftentimes, consumers choose to work with a third party (either a debt settlement firm or an attorney) to negotiate on their behalf, although it’s possible to do your own creditor negotiations.

If working with a debt settlement company that promises to negotiate the settlement on your behalf, the typical process requires the consumer to  make monthly payments to the settlement company until enough cash is built up to make an offer to the creditors. In the meantime, your accounts are not being paid, which likely will cause creditors to report late payments to the credit bureaus and severely harm your credit.

Know that there are debt settlement companies out there that do not have your best interest at heart. As with most financial matters, scammers abound, which is why debt settlement firms have been in the Federal Trade Commission’s crosshairs since 2010. That’s when the FTC issued a ruling stating that consumer funds set aside to pay debts must be held in an account at an insured financial institution. The consumer, not the debt settlement company, owns and controls the account, and can withdraw from the debt relief service at any time without penalty. It also banned the practice of collecting upfront fees from consumers.

Debt settlement is a negative item that will remain on your report for seven years.

— Joe Crinkley
American Consumer Credit Counseling

Credit damage
But even with a legitimate company, it’s important to understand the impact on your credit. Once a creditor agrees to a reduced payment to settle your account, there is a notation placed on your credit report that says the debt was settled for the less than the total amount owed, says Joe Crinkley, education and development associate for American Consumer Credit Counseling (ACCC), a nonprofit organization.

The downside is that there’s no guarantee a creditor will even agree to accept less than what is owed, and if it does, there are major credit consequences. “Debt settlement is a negative item that will remain on your report for seven years,” says Crinkley. Plus, all of those late and missed payments that took place before your settlement means your credit score will have hit rock bottom, and it’s a long climb back up.

If both your stress level and credit limits are just about maxed out, here’s what you should know about debt settlement before diving in:

It should be a last ditch effort. “Debt settlement is for someone who is in a spot, and there’s no way out,” says Josh Alpert, founder and president of Alpert Retirement Advising in Southfield, Michigan. “You need to be in a situation when this is the last alternative; it’s not something you should venture into thinking it will clear up a few bucks.” In other words, the ideal candidate for debt settlement is somebody who truly can’t make payments no matter how frugal they try to be, he says. If you’re not quite at that point but could use some assistance, credit counseling would probably be a better option for you, says Alpert.

You must be behind on your bills. “A company isn’t going to settle any debts if it thinks it is going to get the full amount eventually,” says Crinkley. That’s why, as frustrating as it is, if you’re still able to make payments, you’re unlikely to be granted  a debt settlement request. “Creditors will only settle a debt if it is well into default,” he says.

“The system is designed for you to make payments for years. The reality is why would a bank reduce your balances if you continue to pay them?” says Leslie Tayne, an attorney specializing in in debt management and debt resolution and author of “Life & Debt.” So while no sound personal finance expert would ever recommend you stop paying your bills, know that it is usually a prerequisite for debt settlement.

It will hurt your credit. The key here is it’s up to you to decide how much credit score matters in the context of your current situation. “Credit scores can’t be looked at in a bubble. You have to consider the totality of your finances. It’s about getting out of a debt cycle,” says Tayne.

If you are way behind on payments and carrying high balances, chances are your credit is already shot, she adds. The black mark of debt settlement may send your credit score plummeting even further, but as she points out, once you are debt-free again, you can begin to rebuild. “If you have no money in the bank and can’t pay your bills, a good credit score doesn’t really do you any good anyway,” says Tayne. 

Who can you trust?
At a time in your life when you are desperate and vulnerable, predatory and less-than-legit companies will try to take advantage, which is one of the reasons many consumer protection experts recommend using extreme caution when considering employing the services of a debt settlement company.

If you decide to move forward, it’s important to go into the process with a level head and do your research, says Tayne. Vet potential vendors by Googling them, searching the company via the Better Business Bureau, and asking a lot of questions about their track record.

Red flags
Be on the lookout for these red flags:

  • Charging upfront fees. The 2010 FTC rule made upfront fees illegal. “Any company not willing to give you information without fees is someone trying to take advantage. Be aware that such companies are going to try to pepper in some language designed to make you worry,” says Crinkley.
    Tayne’s company works on contingency, meaning they earn a percentage of what they save the client. Other companies will charge a percentage of the total debt, usually in the 15 to 20 percent range.  A fee structure based on the amount you save rather than the starting debt amount is generally less expensive – something to keep in mind when shopping around.
  • They agree to take your case right away. “A good debt resolution company will not just take anyone in. It will look at your circumstances to see if there is a limited amount of money, and help you determine how to prioritize living expenses,” says Tayne.
  • Something seems shady. If a debt settlement company is not located or licensed in the state you live in, hasn’t been in business long, uses multiple names on paperwork, has no address listed on its website, or if your gut tells you something isn’t right, run the other way, says Tayne.

It is also possible to try a DIY debt settlement; just know that it isn’t for the faint of heart. In theory, doing debt settlement on your own can save money since you wouldn’t have to share the savings with anyone, says Alpert. However, he adds, debt settlement firms might be better positioned to negotiate on your behalf since they have an established relationship with creditors and might get a better deal.

You need to be in a situation when this is the last alternative; it’s not something you should venture into thinking it will clear up a few bucks.

— Josh Alpert
Alpert Retirement Advising

“It’s a long, arduous process to resolve debt, and it’s complex,” says Tayne. If you don’t have the endurance, financial savvy and organizational skills to deal with the red tape and the paperwork, it might benefit you to work with a professional.

Ready to settle?
Whether you want to give it a try on your own or ultimately choose a third party, here are some final checklist items before going down the debt settlement route:  

Start with some free expert advice. “You want to understand the full consequences of each option you’re considering,” says Crinkley. Talk to as many professionals as possible before you make a final call. Whether it’s a credit counseling agency, a debt settlement firm or an attorney, most legitimate players in this space will allow you a free consultation. “A credit counseling agency, for example, can inform you of all of the options, and how to go about negotiating with creditors on your own,” he says.

Get your argument together before you try to negotiate on your own. Creditors will not just take your word that you can’t afford to pay them. You’ll have to explain why you aren’t able to pay back the debt owed (perhaps even showing documentation), while also convincing them that you have a desire to settle with them, says Crinkley.

Know what you’re getting into. A lot of lenders may be willing to negotiate with borrowers, says Crinkley, but be sure to get your agreement with them in writing; if you’re working with a third party, ask for copies. Until the process is complete, expect to deal with a lot of collection calls. There’s also the possibility you can be sued after months of not paying your bills. “The beauty of working with the right company is we can step in and help you resolve judgments,” says Tayne. “You don’t want to ignore a lawsuit.”

Understand that it’s not a “get out of debt jail free” card. If you have student loans, taxes owed to IRS or owe child support or alimony, those are debts that cannot be reduced through the settlement process, says Alpert. Also worth noting is that often, forgiven debt is considered taxable income by the IRS. The money you save by having your debt reduced will be added to your total income, reported to the IRS on a Form 1099-C, and taxed when you file your return.

The aftermath
After successfully settling your debts, which can take anywhere from a few months to a couple years, consider it the beginning of your next financial chapter, says Alpert. Some people get into debt because of one-time occurrences, such as a job loss, death of a spouse, or medical crisis. But oftentimes it’s because of poor judgment.

“Ultimately, you have to make a change in your lifestyle so you don’t get back into debt,” says Alpert.

As far as your credit report, over time, debt settlement will have less of an impact on your credit score, assuming you are working to rebuild your credit responsibly.

“I know so many people who have said ‘I wish I would have known about debt settlement years ago,’” says Tayne. “It’s not ideal or right for everyone, but there’s no shame in reaching out for help to get to a better place.”

See related: Credit card debt negotiation in 3 (not) easy steps, Debt settlement versus bankruptcy: Which damages credit score most?

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Updated: 01-21-2018