Debt settlement is a process that allows borrowers to settle any unpaid debt they cannot repay in full. This process is a last-resort option for borrowers that need quick debt relief.
How Does the Debt Settlement Process Work?
Suppose you are struggling to repay credit card debt. If you feel overwhelmed and have exhausted all of your options, you can try a debt settlement program.
Debt settlement companies are typically for-profit businesses that offer debt settlement programs. You can have debt settlement companies negotiate with creditors on your behalf to potentially reduce your outstanding debt by paying a fee.
A debt settlement company starts by reaching out to the creditor or debt collector and offering a small percentage of the borrower’s outstanding balance. The creditor can accept or reject the proposed settlement amount or make a counteroffer. After some back and forth, a debt settlement agreement may be reached.
Suppose a financial institution agrees to accept a debt settlement. In that case, you must be ready to provide the agreed-upon sum by a specific date. After the lender receives the settlement amount, the account will close and get a “settled” status.
Many debt settlement companies offer debt relief to borrowers struggling to repay lenders. If you want to work with a debt settlement company, ensure you compare fees and ask numerous questions. The best debt settlement company will explain the process in detail and not sugarcoat the potential risks.
What Type of Debt Can I Settle?
Borrowers can settle all types of debt, such as:
- Medical bills
- Credit card debt
- Personal loans
- Private student loans
While most types of unsecured debt can get settled, the process can be more challenging for certain loans. For example, many people struggle to settle federal student loans. Federal student loans typically have to default before they are eligible for the debt settlement process.
How Much Money Do I Need for Debt Settlement?
In order to take advantage of debt settlement services, you need to have the settlement amount ready. A settlement is a lump sum payment you must provide upfront to the debt settlement company.
Most debt settlement companies will not ask you to provide more than 50% of the outstanding debt. However, the necessary amount varies depending on the individual debt settlement company.
Debt settlement companies cannot start negotiations if they do not know how much money you have to give. Suppose you can only provide 30% of outstanding unsecured debts. Knowing this, the debt settlement company will start negotiations by offering a low amount and trying to avoid settling for the total amount you can provide.
Suppose you cannot provide a settlement right now. In that case, you can typically make monthly deposits to an escrow or savings account. Ensure you have access to the dedicated bank account and that your money is insured by the Federal Deposit Insurance Corporation (FDIC).
Once you accumulate enough money to pay a settlement, the debt settlement company will reach out to the financial institution to start negotiations!
Can I Negotiate With Creditors on My Own?
Working with a debt settlement company costs a lot of money. Is it possible to settle unsecured debt on your own? Yes!
You can negotiate with a financial institution on your own to avoid paying a percentage of your debt to a debt settlement company. Start by reaching out to your creditor and explaining your situation. State why you cannot repay the entire outstanding balance and how much you can provide.
If the creditor is willing to negotiate, there may be a lot of communication. If a settlement agreement is reached, you can drastically improve your financial situation and save money!
Debt Settlement: Is It Worth It?
A debt settlement program seems like an ideal option if you cannot afford to repay your total debt amount. But it is a risky option for several reasons.
Learn about some disadvantages of working with a debt settlement company below.
Failed Negotiation and Increased Debt
Signing up for a debt settlement program does not guarantee that a creditor will settle your debt. In fact, the financial institution may reject all settlement offers.
When debt settlement companies cannot settle debt, the borrower is still responsible for paying the outstanding debt and the fees from the debt settlement program. Many debt settlement companies urge borrowers to avoid making monthly payments during negotiations, which can result in additional interest rate charges and late fees.
Unfortunately, many consumers end up in a deeper debt hole with debt settlement programs.
A debt settlement company will charge various fees for its services. Most debt settlement companies charge a 15% to 25% fee. The settlement fee is either based on the original debt amount or the settlement amount you agree to pay after negotiations.
Suppose you owe $15,000 medical bills and settle for 40%, or $6,000. If the debt settlement company charges 20%, you may have to pay $1,200 to $3,000 in fees! Consider whether you are able to pay the settlement amount in addition to the excess costs.
Worsened Credit Scores
Many debt settlement companies ask borrowers to stop making minimum monthly payments so they can deposit into an escrow account. Missed payments will result in late fees, and eventually, you may have delinquent accounts.
Delinquent accounts will stay on credit reports for up to seven years and decrease credit scores. Once an account defaults, the financial institution may send the unsecured debt to a Debt collection agency or issue a lawsuit against you.
If you are sued, you must respond through an attorney or on your own. Do not ignore a lawsuit, or you may face a judgment by default.
Keep in mind that there are tax consequences for debt settlements. Borrowers must pay tax if the forgiven debt amount is more than $600. According to the Internal Revenue Service (IRS), forgiven debt is taxable income. Suppose you settle a $20,000 personal loan for $8,000. You will have to pay taxes based on the $12,000 forgiven amount.
Five Warning Signs of Debt Settlement Scams
Debt settlement scams are, unfortunately, a risk to borrowers looking for debt relief. However, there are red flags you can spot to avoid working with an illegitimate debt settlement company.
If you encounter a scam artist, know you can report the company to the Federal Trade Commission (FTC).
Red Flag Number One: Guarantees
Debt settlement companies cannot, and should not, make guarantees of any kind. A guarantee signifies that you may be dealing with a scam artist.
While a debt settlement company can negotiate with creditors, there are no guarantees that a settlement can be obtained. Financial institutions can reject any and all settlement offers.
If you are frustrated from dealing with debt collectors, you may want to work with a debt settlement company right now. After all, debt collectors can be ruthless. But if a company promises to stop all debt collection calls, it’s a sign to be wary.
Red Flag Number Two: No Clear Answers
A legitimate debt settlement company should be able to answer your questions. If an agent avoids answering simple questions, such as the cost of fees or how long the process may take, this may be a sign to avoid working with the company.
Red Flag Number Three: Upfront Fees
Debt settlement companies are paid a percentage based on your total debt amount or the total settlement amount. However, if a company asks you to pay before starting negotiations, they are a scam! According to the Federal Trade Commission, a legitimate debt relief company can not legally make you pay upfront.
Red Flag Number Four: No Contact Information
If you cannot easily find contact information for the debt settlement company online or through their website, you should proceed with caution. Anyone can make a website, but you may be dealing with a scam artist if you cannot find a credible address or customer service phone number.
Red Flag Number Five: No Agreement
Legitimate debt settlement companies will list the terms and fees in an agreement. Scam artists will often attempt to keep claims verbal. But even if you receive a written agreement, read through it to ensure it is legible and accurate. Spelling errors and omitted details are typically red flags.
Is Debt Settlement the Same as Debt Consolidation?
Debt settlement and debt consolidation are both debt relief options, but they are entirely different.
Debt settlement means negotiating with a creditor to try and pay less than you owe. A debt settlement program can reduce the amount you pay to a creditor. Still, your credit will significantly decrease, and your credit report will have a negative account. A decreased score and a settled status on your credit report may reduce your financial opportunities in the future.
On the other hand, debt consolidation is when a borrower uses a new loan or line of credit to merge various accounts and pay off existing debt. Debt consolidation can help borrowers save money and simplify their financial situation. As long as you continue making debt payments on time, your credit score may only drop a few points from the loan application.
Consumers that consolidate debt may be able to achieve the following:
- Get a shorter or longer repayment plan
- Switch from a variable to a fixed interest rate
- Get a lower interest rate
- Get reduced monthly payments
- Fewer monthly bills to worry about
Borrowers can consolidate unsecured debts with different types of loans, depending on their financial background and how much money they need.
Can I Get Debt Relief Without Working With a Debt Settlement Company?
Debt settlement may seem like a convenient option if you find yourself struggling to pay back debt. However, it can be a risky option. The good news is that there are alternatives to debt settlement programs!
Take a look at some alternative debt relief options below:
Start a Budget Plan
A budget is a detailed plan on how to spend your money. Planning how you will use income ahead of time can increase your spending power and save you money. You can try various budget plans, and the best method depends on your unique financial goals and existing bills.
There are three critical steps to starting a budget plan:
Step 1: Calculate Your Monthly Income
In order to build an accurate budget plan, you need to know how much money you have available to spend. It’s essential to use your after-tax income, not gross income since that is the amount you actually receive.
You can calculate your monthly after-tax income by adding up all the weekly or biweekly paychecks you receive within a month. If you receive irregular income, you will need to use an estimate of your average monthly earnings. You can get an accurate estimate by gathering your payment information for the last six months. Add up six months of wages and divide the total by six. Your final answer is the average amount you earn monthly.
Step 2: Calculate Your Monthly Expenses
Once you know how much you earn monthly, you can start tracking your spending. Knowing how much you spend money every month can help you build better spending habits.
You can calculate monthly expenses by looking at bank and credit card statements. Divide your monthly expenses into two categories: essential and nonessential. Essential expenses include housing, groceries, utility bills, etc. Nonessential bills are ones you can cut or reduce. This includes subscription plans, coffee shop purchases, gym memberships, etc.
Being able to see where your money goes every month makes it easier to cut bills. For example, getting coffee twice a week may only cost $12. But that small weekly bill is a $48 monthly bill and a $576 annual bill! Reevaluating your spending habits can keep more money in your pocket for investments, savings, and more.
Step 3: Choosing a Budget Plan
You can choose a budget plan once you know how much you earn and spend monthly. There are several budget methods you can try. To pick the best budget plan, consider what you want to achieve and how much effort you want to expend.
These are a few standard budget plans:
- Zero-Based Budget: Every dollar you have must go towards a specific financial category. By the end of the month, you should have no money in your checking account. Extra money should go towards an emergency fund, debt repayment, investment, etc. This budget plan ensures that every dollar has a purpose.
- 50/30/20 Rule: This simple budget plan separates your monthly income into three categories: needs, wants, and savings. According to this plan, 50% of your income should go toward necessary bills, 30% toward unnecessary bills, and the remaining 20% into a savings account.
- Envelope System: This budget plan uses cash, which may help you track your spending better. You will need to label envelopes with different categories and determine the budget for each. Suppose you only want to spend $100 this month on entertainment. In that case, you keep $100 in the entertainment envelope. Once you are out of money for a category, you must wait until next month to get more.
- Pay-Yourself-First Budget: The budget plan can help you prioritize savings and debt repayment! Determine how much you want to set aside every month for debt payments or savings and spend the rest of your income how you like. This budget plan is perfect for you if you aim to achieve financial freedom.
- The ‘No’ Budget: This budget plan can help you change your money habits by practicing self-discipline. You will have to get used to telling yourself “No” more often when contemplating unnecessary purchases. While an ad-free Hulu subscription would be nice, you are better off without another monthly payment on your calendar. This budget plan can be initially hard for impulse buyers, but practice helps us build better habits.
Refinance Existing Loans
Refinancing can be an excellent debt relief option for many borrowers. Refinancing is the process of replacing an existing loan agreement with another. Borrowers can refinance various loans to obtain lower interest rates, switch interest rate options, get extended repayment periods, or switch lenders. If you are struggling to repay personal loans due to high APRs, refinancing could help you secure lower rates!
Use a Debt Consolidation Loan
Consolidating debt means merging multiple debts into one account. Debt consolidation can help borrowers avoid late payments by reducing the number of bills they have to pay. In addition, borrowers may save more by securing a lower interest rate! Several loan options for debt consolidation exist, but many consumers use personal installment loans. Personal loans tend to have flexible qualification requirements and decent rates.
Use a Balance Transfer Credit Card
Do you have a lot of personal credit card debt? You could consolidate that debt by using a balance transfer credit card. Credit card companies offer balance transfer credit cards to help borrowers consolidate various credit card debts into one account.
Balance transfer cards may come with a zero-interest introductory APR period. But ensure you ask about the standard rate after the promotional period ends and take time to compare balance transfer fees.
What Is a Credit Repair Company?
A credit repair company, or credit services organization, is a company that helps borrowers repair their credit. Credit repair companies can help borrowers develop a debt management plan and remove incorrect information from credit reports.
Credit repair companies are typically for-profit, which means you must pay to take advantage of their services. The way credit repair companies charge customers differs. You may have to pay a monthly fee between $50 to $100. Or the company may have a “pay per delete” payment option that only charges you when an item on your credit report is deleted.
Incorrect information on a credit report can have negative effects on credit scores. For example, inaccurate reporting of an account status can decrease your credit rating and affect loan applications.
Is a Credit Repair Company Worth the Cost?
If your credit score is bad, you may ask, “Is a credit repair company worth the money?” Truthfully, you can remove incorrect information on your own without paying!
You can file a dispute with the credit bureau if you notice an error on one of your credit reports. Consumers can file disputes online, by phone, or by mail.
Be prepared to provide the following details:
- Contact information (address, phone number, and email address).
- Details of the mistake (account number, date, amount, etc.).
- An explanation as to why you are disputing the information.
- Report confirmation number (if available).
The credit bureau will conduct an investigation and report to you once it is complete. If the credit bureau verifies the mistake, your report will be updated!