Debt settlement pros and cons you should know
It’s not exactly breaking news to say that Americans are a little overstretched.
As of the end of 2022, the country’s total household debt reached just under $17 trillion. For perspective, that translates to over $100,000 in debt for every American.
Fortunately, taking on more debt than you can handle isn’t a foregone conclusion.
One potential lifeline available to everyone is a thing called “debt settlement”. In short, it’s an agreement where a creditor—or a debt collector—forgives a portion of a borrower’s debt.
If it sounds too good to be true, that’s often because it is.
While the benefits of debt settlement can help under the right circumstances, it’s not for everyone.
Keep reading to learn what debt settlement is, when you should consider it, its pros and cons, and more.
What is debt settlement, and how does it work?
Debt settlement is a strategy borrowers can use to help lower the amount they owe.
In simple terms, it's essentially an agreement with a creditor or debt collection agency to write off some of your debt. After all, the creditor would rather get something rather than nothing.
(These deals are especially appealing to debt collectors who buy your debt from creditors at pennies on the dollar.)
While it's not a requirement, borrowers often work with an attorney or debt settlement company. Although the exact steps can vary, here's an example of a typical process using a debt settlement company:
- Hiring a specialist: The debtors begin by hiring a debt settlement company. The primary benefit of using a specialist is that they have a working knowledge of the debt settlement process and will negotiate directly with the creditor.
- Cease payment on existing debt: If using a debt settlement company, the borrower will stop paying creditors. Instead, monthly deposits will be made in a special, separate account.
- Negotiation: The next step involves the debt settlement company negotiating directly with the creditor on the borrower’s behalf. This part of the process can sometimes take several months to complete. The goal of the negotiation is to reduce the outstanding balance as much as possible. The creditor may agree to a lower amount if they believe they will not receive full repayment. In other words, think of it like the creditor cutting their losses; they may as well take some repayment than risk receiving even less.
- Settlement: Assuming the creditor agrees to the revised terms, a formal settlement agreement will be formed. The agreement will usually declare the outstanding debt as paid in full upon receipt of the newly negotiated lower amount.
- Payment: The creditor will be paid the new, lower amount owed, usually in a lump-sum payment taken from the separate account.
Non-profit debt counseling agencies vs. for-profit settlement companies
Many debtors leverage the services of a non-profit debt counseling agency.
As you can imagine, a non-profit agency has a different motivation than a for-profit debt settlement company. After all, settlement companies exist to make a profit.
The biggest difference from the borrower’s perspective is how each helps reduce your debt.
Counseling agencies primarily help debtors through education and mentoring on money management. Meanwhile, debt settlement companies actively work to reduce the balance you owe.
|Credit counseling agency
|Debt settlement company
|Lower than debt settlement companies.
|Higher than credit counseling agencies.
|Debt management programs (DMPs), debt management advice, and financial education.
|Debt negotiation and management.
|Credit counseling agencies may help reduce a borrower’s monthly payment through a Debt Management Program (DMP). Usually, this is achieved by negotiating a longer term with the creditor (not by reducing the interest rate).
|Debt settlement companies aim to lower the amount a debtor owes to the creditor.
|Credit counseling agencies will deal directly with the creditor to extend the loan term and help stop the creditor from taking collection action.
|Debt settlement companies often recommend borrowers cease debt payment until a settlement is reached. In its place, a special account is created to allow the borrower to make payments each month. This account is later used to pay a lump sum to the creditor assuming negotiations were successful.
|Since the balance typically isn’t reduced, there is no credit impact on the debtor.
|Because the amount is usually renegotiated lower, it can adversely impact a debtor's credit rating.
Ways a debt settlement deal will affect your credit health
Debt settlement shouldn’t be pursued without fully understanding all the costs. While a successful settlement can result in more manageable debt payments, it will likely negatively impact your credit health in several ways:
- Negative marks: Your credit report will show the debt as “settled” or “paid settled” for seven years, a potential red flag to future creditors.
- Score reduction: Settling debts for less than the original amount can significantly lower your credit score.
- Trouble obtaining new credit: Settling a debt may lead to difficulty obtaining new credit.
Debt settlement pros and cons
|Offers financial relief through a negotiated settlement.
|Can negatively impact your credit score initially.
|Can help resolve legal proceedings with a creditor.
|Debt settlement companies charge fees.
|Can help clear debts faster.
|No guarantee of success.
|Working with a debt settlement company can reduce stress and anxiety.
|Forgiven debt may be deemed taxable.
|Provides debtors with a structured payment plan.
|Debtor loses some control over their debt management.
When debt settlement may be the only way out
As mentioned above, debt settlement can adversely affect your creditworthiness. Still, for some people, in some instances, it may be the best solution.
- Overwhelming financial hardship: Sometimes, debt is insurmountable. No matter what the debtor does, they simply can’t keep up with servicing the obligation.
- Avoiding bankruptcy: Debt settlement can help some people avoid declaring bankruptcy which can have an even greater negative impact on one's credit score.
- Legal pressure: When a creditor pursues legal action, debt settlement may be the most prudent action a debtor can take to help resolve the situation.
Don’t know where to start? Talk to an advisor.
Most people would rather bury their heads in their pillows than contemplate resolving their debt.
Understandably, debt issues can be overwhelming, and the thought of a lengthy resolution doesn't make it any easier.
If you're stuck, consider speaking to a financial advisor for guidance.
You don't need to commit to any long-term plan. Just have a brief chat and ask for potential courses of action in your situation. There's nothing to lose and a lot to potentially gain.
At the very least, you'll get to know your options.