Debt settlement is a process of negotiating with creditors to accept a percentage of the full amount on debt that is charged off or severely delinquent.

Settling Debt On Your Own

Debt settlement may be a potential solution for some consumers with severely delinquent debt. When you fall further and further behind on your payments, some creditors will agree to settle your debts rather than not get paid at all if you file for bankruptcy. While it’s not easy, consumers are sometimes able negotiate with their creditors on their own to try and arrange a mutually agreeable solution. In exchange for an agreed-upon one-time payment —typically between 40% and 80% of what you owe — the creditor forgives the rest of your debt and will then report it to the credit bureaus as settled. Most creditors won’t negotiate with consumers who are current on their bills.

Using a Debt Settlement Company

Debt settlement companies do a lot of advertising and make claims about how easy it is to free yourself from a mountain of debt. These are generally for-profit companies that have one goal: to make money. Their employees are often paid on a commission basis, based on the fees they collect from consumers.

A settlement company will attempt to negotiate a settlement offer with your creditor after you pay them enough money to make a reasonable settlement. They may suggest that you stop paying your creditors and instead begin making deposits into a special escrow account. However, your initial payments — totaling hundreds or even thousands of dollars over a period of months — may go toward paying fees to the debt settlement company before any of your money is set aside to begin accumulating for payment to your creditors.

During this time, the balance on your debt can continue to grow if interest and penalty fees continue to be charged by your creditor. The result is you may owe more than when you started and your credit may suffer. Even worse, your creditors may take legal action against you. Any missed payments to your creditors will reflect very negatively on your credit report. And, if any debt is actually settled, you will likely owe income taxes to the IRS on the forgiven amount.

If you decide to use a debt settlement company, you can expect to give the names of your creditors and the amount you owe. The debt settlement company then gives you an estimate for reducing your debt along with a new, lower monthly payment. As advised by the settlement company, you stop paying your creditors and instead send payments to the debt settler.

The first one to four payments you send will likely go directly for the settlement company’s fees. The remaining payments are put into an escrow account. Once the account has grown to a certain amount whereby a lump sum payment can be made, the debt settlement company contacts your creditors and begins negotiating a settlement with them.

Beware of Potential Pitfalls

On the surface, the option of debt settlement might look attractive. You pay the debt settlement company who, in turn, pays your creditors. In the end, everyone gets paid, you save some money, and you’re able to move on with your life. Remember the part about stopping payment to your creditors while a settlement is negotiated? That’s the part that can cause some serious damage to your credit history.

Creditors don’t typically settle debts until they’re seriously delinquent. That means you have to stop paying your accounts. Meanwhile, late payments continue to accrue and are reported to the credit bureaus. Your credit score drops, you might begin receiving collection calls and you may be sued by your creditors. Late payments will remain on your credit report for up to seven years. Until you replace the negative payment history with some positive information, you’ll have difficulty getting new credit cards and loans. You may even have a hard time getting a job or a competitive insurance rate.

If the debt settlement company successfully settles with your creditors, the delinquent information isn’t erased from your credit report. Instead, your account is updated as “Charged-Off Settled” Or “Paid-Settled,” neither of which is as good as a “Paid in Full” account.

You will likely owe taxes on settled debts. The IRS treats forgiven debts as income and expects you to pay income taxes on it. Creditors will send you a Form 1099-C for reporting cancelled debts, but you’re supposed to include the debt in your tax return even if you don’t receive the form.

In conclusion, you must exercise caution when exploring this option. While you could save money, the negative aspects could be long-term. Look into a debt-management program and see if that would be a better option for you.

NOTE: The information contained herein is for educational purposes only and is not legal advice. You should seek advice from a legal professional regarding your particular situation.

It May Be Helpful to Talk to a Financial Counselor

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