Debt Settlement 101: A Comprehensive Guide

By Allison Martin Last updated Jan 18, 2020

Debt settlement entails paying creditors less than you owe to cover your outstanding debts. In exchange, you’ll be off the hook with debt collectors. Even better, they will release you from all liability and won’t be able to file a lawsuit against you in the court of law.

It can offer a peace of mind if you’re buried in debt and can’t seem to find a way out because your finances are in shambles. But it takes some time to legwork to pull it off whether you hire a debt settlement company or take the DIY route. And there are some negative implications you should consider.

Read on to learn more.

Potential Benefits of Debt Settlement

You’ll have peace of mind.

No more ducking and dodging debt collectors or tossing and turning at night worrying about your debt. By settling your debt, you’ll be able to put your dark financial past behind you, move on with your life, and focus on fresh financial goals.

You’ll reduce the financial blow to your wallet.

Assuming your attempt at debt settlement is successful, you’ll save a wad of cash by only paying a portion of what you owe to the creditor. This will free up funds to work on accomplishing other key financial objectives on your list, like building an emergency fund or contributing to your retirement account.

Risk Factors

There’s a 50:50 chance it won’t work out.

Creditors aren’t obligated to accept your debt settlement offer. In fact, they can do the opposite and choose to pursue you in the court of law, especially if they sense that you have the wherewithal to pay.

And there’s also a chance that the creditor is willing to settle, but for an amount that’s too high or doesn’t quite work for you. Either way, you’ll have to deal with damage to your credit profile and find a way to take care of your outstanding debts, plus additional interest, fees, and penalties incurred from withholding payment.

Does Debt Settlement Impact Your Credit Rating?

While debt settlement does negatively impact your credit score, the damage starts far before an agreement is reached (if at all). How so? Well, debt settlement companies advise consumers to cease payments on their outstanding debt obligations during the process and divert the funds to a savings account, instead. When the account reaches a certain amount, they will commence negotiations on your behalf. And if an agreement is reached, the funds from this account will be used to settle the debt.

This is done for a few reasons. For starters, most creditors will only agree to the terms and conditions of a settlement offer if the amount can be paid in full. So if you don’t have the funds available and they say yes, you’ll be out of luck. Furthermore, creditors are less likely to accept a settlement offer if they suspect you’re able to repay what you owe. And by continuing to make monthly payments, you’ll lower your chances of them biting the bait.

The problem is that by forgoing monthly payments in an effort to save up, your credit rating will take a hit once the payment is late by 30 days or more. And depending on how severe the delinquency gets, the account could be written off by the creditor and converted to a collection item.

But what if you reach a settlement before the account is written off as a collection item? The creditor will note that it has been settled for less than the total amount owed and the entry on your credit report will still ding your credit rating.

Other Important Considerations

Costs

When you hire a debt settlement company to negotiate a reduced payoff on your behalf, you may not incur any out of pocket costs right away. On the other hand, they may assess an administrative fee that is withdrawn monthly from the savings account that contains the funds that will be used to pay off the debt.

And when they do reach a settlement that works for both parties, they will usually deduct a percentage of the settlement amount or the total amount eliminated by the settlement.

To illustrate, assume you initially owed $16,000 and the debt settlement company you hired negotiated a settlement for $7,500.

If the company charges 20 percent of the settlement amount, you’ll pay $1,500 ($7,500 * 20%) in fees and $7,500 to the creditor.
If the company charges 20 percent of the total amount eliminated by the settlement, you’ll pay $1,700 ($8,500 * 20%) in fees and $7,500 to the creditor.

Tax Implications

The creditor may appear to be generous by accepting your offer, but Uncle Sam isn’t always as forgiving. In fact, you may be on the hook for additional income tax with the Internal Revenue Service (IRS) because the amount that’s forgiven may be classified as taxable income. If you’re unsure of if you fall into this category, it’s best to solicit guidance from a reputable tax professional.

How to Find a Debt Settlement Company

Are you ready to bring a debt settlement company on board to go to work on your behalf? Don’t settle for the first company you find on the internet. Here are some key factors to look for along with some of the top options in the debt settlement industry.

Evaluating your options

When shopping around for debt settlement companies, you want to consider companies that:

Are licensed in your state of residence, which can be confirmed by contacting the Attorney General’s office in your state.
Are accredited by the Better Business Bureau (BBB). An A+ or A rating is also ideal.
Are affiliated with professional organizations in the industry.
Offer free consultations so you can gauge which companies are best suited to fit your needs.
Only assess fees once they’ve negotiated and executed a settlement on your behalf. (Note: some companies charge setup and administrative fees over the course of your time as a client).
Have minimal complaints on file with the BBB, State Attorney General, or the consumer protection agency in your local area of residence.

Don’t know where to start? Key industry players, like Freedom Debt Relief and National Debt Relief, can analyze your situation and get you moving in the right direction. You can view our comprehensive list of top debt settlement companies here (insert hyperlink once the article is published).

DIY Debt Settlement

Do you think you have what it takes to settle your own debts without bringing a company on board? It’s worth a shot if your debts are already severely past due, around 90 days or more, and you the funds at your disposal to make a lump-sum payment.

By settling your own debts, you’ll always save money as you won’t be required to pay a fee to a service provider to set up an account or once a settlement is reached.

Ready to get started? Take the following steps:

Step 1: Assess your finances to determine if you have the funds on hand to make a lump-sum payment. Oftentimes, the creditor will request that you settle the debt at once at not over time with multiple payments. And if you reach a deal but are unable to follow-through, they may be reluctant to work with you again on reaching a deal.
Step 2: Draft up your game plan. While you could just call up the creditor and ask to pay less than what you owe with no specific reasoning, you may find it harder for them to accept your offer. A better idea: compose a pitch that explains your financial hardships and point to the fact that you’ve already missed a few payments. That way, they’ll know that the chances of you paying off the balance in full are slim to none. Also, decide on the starting point of your negotiations. You want to give yourself wiggle room just in case they reject the first few offers. So, if you can comfortably by 60 percent, start at 30 percent and work your way up.
Step 3: Contact the creditor once you have the funds in hand and are ready to negotiate a settlement amount. There’s a high possibility that you may not be successful the first or even second time around, but the key is persistence. It may also be necessary to move up the management ladder to get the results you’re looking for.
Step 4: Seal the deal. Before you hand over your hard earned cash, be sure to get the final agreement in writing from the creditor. That way, you’ll be covered and can rest assured that the creditor is playing by the rules. But keep in mind that the creditor will also expect you to uphold your end of the deal.

The Bottom Line

Whether you decide to hire a debt settlement company or work out deals with creditors on your own, you may be able to find the relief you’ve been searching for. But before deciding on a course of action, be sure to explore all your options to decide if debt settlement is the best fit for your financial situation.