A May 2024 consumer credit report from the Federal Reserve noted that outstanding debt (including credit card balances) grew by $11.4 billion from the previous month. Many Americans may be part of that growth and wonder how to get rid of their debts.
You might be experiencing increased credit card debt resulting from higher costs and reduced savings. If that debt is overwhelming or you’re encountering severe financial hardship, you might be ready to buy into some of the promises offered through debt settlement.
Debt settlement can be helpful if you’re struggling with overwhelming debt. It also has its share of myths and misconceptions. It’s essential to understand what debt settlement is and know the differences between taking the process into your own hands or enlisting the assistance of a third-party debt settlement company.
Debt settlement: What it is and how it works
Sometimes known as debt relief, debt settlement occurs when you and a creditor agree to settle debt for less than what you owe. That settlement can involve reducing the principal amount in exchange for a lump-sum payment or decreasing the interest rate.
Debt settlement might be a good option if:
- You’ve struggled for a long time to pay down your debts.
- Your debts are more than 120 days past due and/or have been submitted to collections agencies.
- You’re suffering financial hardship and can’t pay what you owe.
- You can set aside money for a lump-sum payment.
- Creditors frequently harass you.
It’s important to remember that most settlement agreements won’t eliminate your entire debt. Furthermore, it isn’t a “quick-fix” process – a successful debt settlement can take up to five years.
Something else to consider is that the IRS considers the settlement as taxable income. Even if you succeed in reducing what you owe, you might have to pay more at tax time.
Finally, that settlement stays on your credit report for seven years, which could hamper your ability to get a mortgage or auto loan.
The first step to deciding on debt settlement is carefully analyzing your financial situation and determining that this method offers the most benefits. Once you’ve determined this, it’s essential to understand the two available debt-settlement processes: Doing it yourself or partnering with a third-party company.
How to do your own debt settlement
The DYI method of debt settlement involves contacting each creditor you owe, presenting your case, and keeping your fingers crossed that the creditor cooperates.
Here are the steps to take if you’re considering a DIY debt settlement.
1. Verify your eligibility
Write down a list of your creditors, then note how much you owe and how far behind you are on payments. You could realize that maybe you’re not as bad off as you thought.
For instance, if you’re behind in payments by a month or two, one solution could be to request a hardship payment from the creditor instead of a full-fledged settlement request.
2. Study creditor requirements
Not all creditors’ debt settlement policies are the same. Sometimes, you might need to be at least 90 days delinquent on an account before a creditor will discuss settlement terms with you.
Others might flat-out refuse to settle with you. In this case, you must wait until that debt is turned over to a third-party collection agency, then negotiate with that agency.
Knowing everything you can about the creditor can help you when it comes to negotiating.
3. Contact the creditors
This step seems simple: You call each creditor, outline your financial hardship and reasons for debt settlement, make your offer and both of you walk away happy.
This could happen, but it’s more likely that you’ll need to make multiple calls and propose several settlements before you and the creditor agree. The process could also involve calling several people at the same company.
As a caveat, be sure you can reasonably afford your offer. Suggesting that you settle 75% of what you owe, for instance, doesn’t do much good if you don’t have the means to pay it.
4. Get it in writing
Once you and the creditor agree on a settlement, get it in writing and review what’s written. That agreement should outline specific terms of the settlement (like how much will be paid and any deadlines). Make sure the agreement states that your payments will take care of the obligation.
5. Honor the agreement
Creditors are required to honor a debt settlement agreement. But here’s what you don’t want to do: Sign an agreement, then ignore it. If you don’t pay what’s specified, the creditor has every right to move forward using a previously planned debt collection method.
Pros and cons of DIY debt settlement
Pros
- It can save costs.
- It could help resolve debts more quickly.
- It gives you control over the process.
Cons
- It can be time-consuming, as you must work with each creditor.
- It requires consistent negotiation skills and “pushiness."
- It demands organization, patience and persistence.
How to work with a debt settlement company
If you know you’re a poor negotiator or don’t have the time or patience to deal with every creditor, another option is to work with a third-party debt settlement company. That company will contact creditors on your behalf and attempt to strike an agreement that works for you and the creditors.
Reputable debt settlement companies have the experience and know-how when working with creditors on debt settlements. That’s an advantage. However, they might also tell you to stop making payments to creditors while they negotiate.
Instead, they’ll direct you to put those payments into a special escrow account. Once an agreement is struck, the debt settlement company will pay the creditors from the escrow account.
The idea behind halting payments is that creditors might be more willing to negotiate. However, these delays could have a severe impact on your credit score.
This is also an industry that attracts multiple bad actors. Because of this, you need to take the following steps to ensure you’re working with a dependable debt settlement company.
1. Research the track record
Your target company should have been active for a while — years, if possible. Be wary of newer companies. Also, check out reviews, especially on third-party websites. Look for consistent critical comments about customer service, processes and resolutions.
2. Check out accreditations
Yes, there are accreditations for debt settlement companies. The American Association for Debt Resolution audits members to ensure they follow regulations. Also, be sure your counselor is certified by the International Association of Professional Debt Arbitrators.
3. Know who you’re working with
When you ask a debt relief company about costs and the word “commissions” comes up, move on. Commissions signify that your “counselor” is a salesperson who’s in it for the money rather than to help resolve your debt. This is not someone who will work in your best interests.
4. Ignore “come-ons”
You might be listening to talk radio or watching late-night television when an ad appears. The ad promotes a debt settlement company that claims it can settle your debt for pennies on the dollar, stop harassing calls and guarantee a solution.
A trustworthy debt settlement company will only make such promises if they know your situation. If any company advertises this or approaches you with these “assurances,” ignore it and move on. And never pay an upfront fee before a company has done some work for you.
Pros and cons of debt settlement companies
Pros
- You have a single point of contact rather than working with multiple creditors.
- Reputable companies know how to negotiate with stubborn creditors.
- Trustworthy companies are transparent and have your best interests in mind.
Cons
- You’ll pay a fee of 15 percent to 25 percent of the debt involved once you settle, plus set-up fees for accounts.
- Your credit score could be further damaged by non-payment.
- Late fees and penalties could be higher than what’s in your escrow account.
Alternatives to debt settlement
Even if you’re deep in debt, there are options other than debt settlement to consider.
Debt consolidation loans or balance transfer credit cards
Consolidating what you owe (either through a personal loan or a balance-transfer credit card with a 0 percent interest introductory period) can help reduce your multiple payments into a single monthly payment. Also, depending on the loan or card, you could pay less interest than what you currently owe.
However, if you use a credit card for consolidation, pay off the balance before the introductory period ends, or you could face higher interest costs.
Debt management/credit counseling
Working with an accredited nonprofit counseling agency can help you develop a debt management plan (DMP). Many also negotiate with creditors to set up repayment plans and, in some cases, to eliminate interest or penalties on what you owe. You make one monthly payment to that counseling agency, which pays the creditors until your debt is resolved.
Working under such a plan usually means closing all outstanding accounts until the debt is paid off. You shouldn’t apply for new credit cards or loans while on a DMP. For one thing, adding more debt to your life while paying what you already owe is counterintuitive. For another, once your current creditors find out you’re applying for a new credit card, they could void the benefits you’re currently receiving on the DMP, such as lower interest rates and monthly payments.
Bankruptcy
Bankruptcy is usually considered a last resort, as it stays on your credit account for at least seven years after resolution. But if you’re worried about the consequences of debt relief or are too deep to consider a debt management plan, asking the courts in your state to help might be a viable option.
There are two bankruptcy options available in most states:
- Chapter 7 (liquidation), in which non-exempt assets are sold, with proceeds going to creditors
- Chapter 13 (repayment), in which you and the court agree to a repayment plan to settle your debts
Keep in mind that while bankruptcy can remove credit cards, medical debt or certain types of loans, it doesn’t get rid of back taxes, student loan debt or child support.
The bottom line
If you feel you’re drowning in debt or enduring financial hardship, debt settlement may help you turn the corner. But before deciding on this course, be sure that other options aren’t available and understand the pros and cons of DYI settlement or going through a third-party source.
To determine which process is in your best interests, take the time to understand your financial situation, abilities and what to expect. Additionally, remember that you can change course if your debt settlement efforts aren’t working out as planned.
