Debt settlement is the process of negotiating with your creditors - including banks, credit unions, and other lenders - to pay less than the full amount you owe on your loan. Paying less than the full amount you owe to your creditors sounds amazing and seems like a no-brainer, but there are risks as well. You can try to “settle” your outstanding debt yourself or through a debt settlement firm. In either case, you’ll need a good understanding of how debt settlement works, what the pros and cons of debt settlement are, and how it weighs up versus the other options such as debt management or declaring bankruptcy.
The debt settlement process can vary slightly depending on whether you choose to do it yourself or have a third-party company like Freedom Debt Relief or National Debt Relief get a debt settlement for you. At a high level, concepts can be similar.
First, are you a good candidate for debt settlement? Many creditors won’t consider debt settlement unless you are at least 90 days delinquent. According to a Nerdwallet article, 5 months delinquent and not making monthly debt payments could be the right time to consider negotiating for a debt settlement. This is also around the time your lender might sell your debt to third-party debt collectors.
Have you considered other options like bankruptcy and credit counseling? Debt settlement isn’t always the right option for everyone. It can lead to an additional decrease of your credit score, more debt and fees, and additional financial burdens.
Are you a good negotiator? Confidence can be key to getting a good debt settlement result with your bank or financial institution. If you believe you can settle your debt for a small proportion of the total amount you borrowed, you probably can. Each lender is different but knowing what each side wants and being a savvy negotiator will help you get to the finish line.
Below are the steps in a normal debt settlement process, whether you do it yourself or have a third party company help:
You’re looking to negotiate two main things - payment and credit.
Payment. Settling for paying 40-50% of the amount you originally owe can be feasible depending on the lender and depending on how well you negotiate your debt settlement. You’ll also want to nail down the revised timing and term of those payments. Hint: Don’t be too optimistic - give yourself plenty of time and room to make your revised payments.
Credit. Although your credit report is likely a mess after the many delinquent marks against you (see earlier question about whether you’re a good candidate for debt settlement), you’ll want to slightly redeem yourself by getting your creditor to mark the settled debt account as “Paid as agreed” rather than “Settled” or “Paid Settled” on your credit report.
Below are some tips while negotiating:
So should you negotiate a debt settlement arrangement yourself or use a debt settlement company to negotiate on your behalf? The primary differences are time, effort, and money.
Time. Debt settlement companies can take longer than doing it yourself. Completing a debt settlement plan with a debt settlement company may take as long as 3 years whereas doing it yourself can be as short as 6 months. If you’re willing to take the credit score hit, you can go delinquent immediately and look to negotiate a settlement 3 to 6 months after that. Who knows what your economic and personal situation looks like 2 years from now?
Money. Debt settlement companies usually charge a 20-25% fee on the enrolled debt once you agree to a settlement and start making your revised payments or make a lump sum payment. In addition, you may have set up and monthly retainer fees related to the debt settlement company as well. That means that the majority of the savings from your debt settlement may go to the debt settlement company! For example, if you are able to reduce your debt outstanding to 50% and your total fees paid to the debt settlement company is 30% of your outstanding, your net savings is only around 20%.
Effort. Unfortunately, negotiating a debt settlement yourself takes effort. You need to understand your financial situation, plan ahead, and negotiate well with your creditors. Putting in the time and effort yourself can pay huge dividends. If you’re able to reduce your debt 50% without having to pay a debt settlement company, that’s huge!
Part of the debt settlement strategy is missing your normal payments to your lender and helping the lender understand that you can’t make the monthly payments by going delinquent. Because you aren’t making your debt payments as agreed upon with your lender, your credit score will be negatively impacted.
But how much? A FICO credit score is a common way banks and many lenders look at your credit history and understand how likely repayment is. A FICO score is calculated using many factors but one of the most important factors in calculating a FICO score is repayment history. MyFICO ran through some examples and missing payments by over 90 days can have an impact anywhere from 30-40 points to as much as 150 points.
Because there is such high variability in how much your credit score could be negatively impacted, plan accordingly. Know that your credit score will drop significantly, plan for the worst, and do everything you need to do w/ a higher credit score before you start your debt settlement. That means applying for the credit card you need, getting lower rates on mortgages and car loans, and debt consolidation programs (if it makes sense).
You’re in a better position to access credit before you start your debt settlement than after. Once your debt settlement is done, settled debt stays on your report for up to 7 years and it may take years to rebuild your credit.
Most unsecured debt is eligible for debt settlement, including:
Why isn’t secured debt like a mortgage or car loan eligible for debt settlement? Secured debt involves collateral in which the financial institution can repossess the collateral used for the loan such as the home or automobile. Therefore, in most cases, the collateral has significant value and it makes more sense for the lender to sell the repossessed collateral than to negotiate a debt settlement with you.
Unfortunately, you won’t escape the taxman and the IRS with a debt settlement. According to debt.org, 4 million people received an IRS form 1099-C and had at least $600 in debt forgiven in 2018.
The Internal Revenue Service (IRS) treats the debt forgiven through debt settlement the same way it treats your weekly paycheck - as taxable income. You should receive a 1099-C tax form from your lender at the end of the year for debt forgiven. Remind your lender if you don’t receive one because you’ll still be responsible for reporting it on your year-end taxes.
For example - suppose you have $20,000 in outstanding credit card debt and you’re able to negotiate that down to $10,000 through debt settlement. That $10,000 in debt forgiven goes on Line 21 of your tax return and will be counted as income according to the IRS.
Are there exceptions? No, there aren’t - in the past through laws passed by Congress, there has been exceptions. The Mortgage and Debt Relief Forgiveness Act passed originally in 2007 allowed for exclusions related to mortgage debt but 2017 was the last year it applied.
Here are the pros and cons of debt settlement. Remember, each person’s situation is different so understanding your personal finances, credit score, and economic situation will help you determine the best way to go.
Debt-related terms can be confusing. It’s important to understand the differences between debt settlement, debt management, and debt consolidation.
Debt settlement is the topic of this article and is also known as debt arbitration, debt negotiation, or credit settlement. It’s a way of debt reduction in which you and your lender/creditor agree on a reduced balance on your debt that will be regarded as paid in full.
Debt management is most commonly associated with a debt management plan (DMP) in which a credit counselor or agency works with a lender/creditor on your behalf to lower payments and interest rates. Your debt amount is NOT lowered through debt management. Your credit counseling agency will also work with you to set a budget based on regular income and expenditures.
Debt consolidation involves re-financing higher cost debt into a new loan with a lower payment. For example, if you have multiple credit cards with high-interest rates, you might consolidate into a personal loan with a lower interest rate and combined monthly payments. Debt consolidation may make sense if you have a good credit score and you need to reduce your monthly payments. It will NOT lower your outstanding debt amount.
So, what can you do if debt settlement isn’t right for you? Or if debt settlement is too much of a risk for common alternatives:
Debt settlement is a controversial process of getting your debt amount reduced with your creditor (bank or financial institution) and isn’t right for everyone. However, people who negotiate the debt settlement themselves and are working with a willing lender can reduce their debt by more than 50% and improve their financial situation significantly. Debt settlement comes with risks though, including a lower credit score, more costs, and fees, plus it may not even work! Evaluate your situation carefully and determine whether debt settlement is the right solution for you.