How Does Debt Settlement Work?

·8 min read

The bills are piling up, and you've got more minimum payments due than you can handle. Luckily, consumers with too much debt have options, one of which is debt settlement.

"Debt settlement providers work directly with consumers experiencing a financial hardship to negotiate settlements with their unsecured creditors for less than they owe," says Denise Dunckel, CEO of the American Fair Credit Council, a debt settlement industry group.

Debt settlement is a private-sector alternative to bankruptcy, Dunckel says. "Applicants should not enter a program lightly," she cautions.

While the benefits include getting rid of debt if a plan succeeds, the drawbacks involve harming your credit score.

Here's how debt settlement works and the pros and cons if you're considering this option to help you get out of debt.

[Read: Best Debt Consolidation Loans.]

What Is the Difference Between Debt Settlement and Debt Consolidation?

Debt settlement can help you reduce your overall debt, while debt consolidation can slash the interest you pay and cut the number of creditors you owe each month.

Debt settlement is "eliminating debt by agreeing to pay less than the amount you owe," says Mike Sullivan, personal financial consultant for Take Charge America, a national nonprofit credit counseling and debt management agency. "Consolidation is borrowing more money to pay off old debt."

Settling credit card debt involves working with a debt settlement company that negotiates with your creditors to allow you to pay less than the amount you owe. If the negotiations succeed, the debt settlement company charges you a fee that is a percentage of your debt or the amount the company saves you, according to the credit bureau Experian.

Debt consolidation allows you to combine multiple debts into one new loan, usually at a lower interest rate. Your debt load remains the same, but you could reduce your monthly payment and simplify your finances by rolling several debts into a single payment.

Home equity loans and lines of credit may be less expensive than debt consolidation loans, but using your home as collateral may put it at risk if you fail to pay.

Should You Request Debt Settlement or Consolidate Debt?

Whether you choose debt settlement or debt consolidation depends on your financial situation.

Typically, debt settlement is for someone facing a temporary but significant financial setback, such as job loss, illness or divorce, Dunckel says. A debt consolidation loan doesn't make debt go away, but it may lower your monthly payment and reduce the interest you pay over time.

"Debt consolidation by taking out a loan is not a bad plan financially," Sullivan says. "If someone owes $20,000 and the average interest rate is 16%, and they can borrow that much on a similar loan for 6%, that's a good idea. You'll save money and lower your payment."

The only problem is that many people who are consolidating debt are doing so because they have a spending problem, Sullivan says. "You can't borrow your way out of debt, he says.

You must commit to changing your behaviors to avoid racking up more debt while paying off your debt consolidation loan.

"If you are going to run up your credit cards again, debt consolidation is not a good option," Sullivan says.

If your only alternative is bankruptcy, debt settlement might be a better choice. "Debt settlement is really only effective if you are about to file for bankruptcy anyway or you have filed for Chapter 13," Sullivan says.

That is partly because debt settlement can be an expensive way to get a modest reduction in debt. Typically, for-profit companies offer debt settlement and take a percentage cut of the settlement amount, often 20% to 25%, according to Experian.

A settled account not only hurts your credit score because you did not pay in full but also counts as taxable income by the IRS. The benefit of settling debt, Sullivan says, is that "it can eliminate debt if you are not going to pay it down anyway."

[Read: Best Personal Loans.]

Do You Qualify for Debt Settlement?

Debt settlement companies generally have a minimum amount of debt that they will negotiate, and some only deal with certain types of debt. Also consider that you'll need to regularly deposit money in a special savings account before your debts will be settled.

"Debt settlement providers review all clients before they enroll to ensure they can make the necessary payments to complete their personalized program," Dunckel says. "The typical debt settlement client owes more than $25,000 in unsecured debt and is already behind on at least one, and in many cases, most of the seven or more accounts they hold."

If you are struggling to find a company that will settle your debts, you could try negotiating some of them on your own. Calling your creditors, explaining that you have a financial hardship and asking whether they could accept less than the minimum lets them know you are trying to make good on your debts. "That sometimes works," Sullivan says.

What Is the Debt Settlement Process?

The typical debt settlement program will require you to make monthly payments into a savings account for a certain period of time and ask you to stop paying your creditors. The idea is that a partial payment could be an appealing alternative to no payment for a creditor.

"When that account reaches a certain threshold, the debt settlement company negotiates with the consumer's creditors to settle their debts for less than they owed initially," Dunckel says. "Once they have an offer from a creditor, providers take that offer to the client, who is under no obligation to accept it."

The escrowlike account where you deposit funds goes toward settling debt, and the debt settlement company takes over paying your creditors, Sullivan says. "Most clients see initial account settlements within four to six months of starting a debt settlement program," she says.

Keep in mind that your debt settlement company may not be able to settle all of your debts, even with the required savings. And you'll still face fees when the settlement is agreed upon. Still, on average, every dollar spent on debt settlement fees can save consumers $2.64, Dunckel estimates.

How Will Debt Settlement Affect Your Credit?

Debt settlement companies usually instruct clients not to pay creditors while debt is being settled, and months can pass in negotiations as your credit score sinks, and late fees and penalties pile up.

"Debt settlement can devastate your credit compared to consolidation, debt management and credit counseling," Sullivan says. "The company might say, 'You are not going to get anything,' and then you're 30 days late, 60 days late, 90 days late."

The negative entries on your credit report, such as charge-offs or collection accounts, remain for seven years from the date of the initial delinquency. The fact that you settled a debt, rather than paid the full amount, also appears on your credit report. These items hurt your chances of getting credit in the future, though their impact will lessen over time.

The FTC says debt settlement can have other consequences aside from a negative impact on your credit report. You could accrue late fees and penalties, resulting in a higher balance due. Creditors and debt collectors could start calling to collect payment and even sue you for repayment or place a lien on your home. However, a study by California-based debt settlement firm Freedom Debt Relief found that credit scores steadily recover for clients who complete the program.

[Read: Best Debt Settlement Companies.]

Is Debt Settlement Worthwhile?

Debt settlement may be worth considering if your only other option is bankruptcy. "There is a lot of risk in debt settlement," Sullivan warns.

Slow down before you select debt settlement to deal with big credit card bills, the FTC advises. Credit counseling and budgeting are other ways to responsibly deal with debt.

"All of these options should be a wake-up call for those who have not done a good job of managing their money," Sullivan says.

Before you enroll in a debt settlement program, do some homework. Check out the company with your state attorney general and consumer protection offices, and search for it in the Consumer Financial Protection Bureau's consumer complaint database.

The FTC says to avoid debt settlement companies that:

-- Charge fees before settling your debts.

-- Promote "new government programs" to bail out personal credit card debt.

-- Guarantee to make your unsecured debt go away.

-- Tell you to stop communicating with your creditors but don't explain the consequences.

-- Inform you they can stop all debt collection calls and lawsuits.

-- Say that your unsecured debts can be paid off for pennies on the dollar.

If you are enrolled in a debt settlement plan, you can cancel anytime without penalty. Dunckel says, "All clients are free to leave a debt settlement program at any time, for any reason, at no cost."