Everything You Need To Know About Debt Settlement
Updated January 27, 2019
When you are overwhelmed by debt, it might feel like a never-ending cycle of bills and payments, but no matter how hopeless you feel, you do have options to successfully pay off your debt.
What Is Debt Settlement?
Debt settlement lets you reduce your total amount of unsecured debt by negotiating with your creditors. This is especially ideal when you are so deep in debt that creditors are willing to settle for less than the amount you owe because of the risk that you may default on your payments.
If you are thinking about settling your debts, know that you can only enroll unsecured debts (which are not tied to collateral, like credit cards and medical debt) into a settlement program. You can even settle your student loan debts.
Although you can negotiate your debts with creditors on your own, it's best to hire a professional debt settlement company to help you with the process. These services know the ins and outs of debt settlement and have leverage with your creditors.
Before you enroll in these services or pursue a DIY route, you should cut your spending for three to six months before settlement. This is crucial because lenders take a look at your expenses to determine whether or not they will be able to reduce your debt.
How Does Debt Settlement Work?
Debt collectors won't settle your debts until your payments are a few months past due. This means that you must stop paying creditors and begin collecting a lump sum of money in a secured trust while negotiations are made with your creditors. Once an agreement has been reached in writing, then you can use your savings to pay off your creditors.
Debt settlement companies charge either a percentage of your total debt (around 15% to 20%) or a percentage of your negotiated debt (around 30%). An FTC compliant company should not charge you any upfront or monthly fees but your bank may charge you a monthly fee for your FDIC-insured trust account.
Once your debts are settled, be sure to get your full agreement with your creditors in writing.
What Are The Disadvantages To Debt Settlement?
While debt settlement gives you a chance to get back on your feet, there are some risks:
- During the negotiation process, your interest and fees accrue, which means you ultimately end up with more debt.
- Your credit will be damaged. Because you do not pay your creditors during the negotiation process, you end up with delinquent payments on your credit report. Some consumers reported that their credit scores dropped as much as 65 to 125 points.
- Additionally, bad credit means it will become difficult to acquire affordable loans in the future. This negative mark stays on your credit report for up to seven years and is listed as "Charge-Off Settled" or "Paid-Settled" on your credit report, which is not as ideal as an account listed "Paid In Full." It may take several years to improve your credit enough to qualify for a line of credit or an unsecured loan.
- You will probably receive collection calls from creditors. However, debt settlement companies will work with creditors to reduce the number of calls.
- Many consumers find it hard to make monthly payments for their FDIC-insured trust account for 36 consecutive months (the average time it usually takes to reach a settlement). If you don't set aside enough cash for your savings, your creditors are not obligated to agree to a settlement.
- Your credit cards may be permanently closed once you pay the settlement.
- You may wind up owing taxes on your settled debt since the IRS treats forgiven debt over a certain amount as income. Creditors should send you a Form 1099-C to report your canceled debt but you should include the debt on your tax return even if you don't receive it.
What Are My Other Debt Relief Options?
If you are deep in debt but want to explore other options, then you may be interested in alternative forms of debt relief:
- Consumer credit counseling: Credit counseling can help you enter a debt management plan with your creditors and give you the opportunity to reduce your monthly payments while still paying your full balance. You can use an agency such as Consolidated Credit in order to make your debt more manageable. As long as you make on-time payments, your credit will not be damaged.
- Hardship plan: You can work out a payment plan with your creditors in the case you have missed a couple of payments. Be sure to ask for a hardship program if you have any financial difficulty. This could help you receive a reduced payment for six to twelve months.
- Bankruptcy: Declaring bankruptcy is another way in which you can take care of the overwhelming debt. Unfortunately, this hurts your credit even more than debt settlement. A Chapter 7 bankruptcy stays on your credit report for up to ten years, while a Chapter 10 bankruptcy and debt settlement only stay on for seven years. A Chapter 7 bankruptcy can take care of unsecured debt but your income can't be above a specific amount to qualify. Even if you do qualify, you may have personal property possessed that goes towards the amount you owe. A Chapter 13 bankruptcy stays on your credit report for seven years, does not have required minimum income, and requires you to pay your creditors for up to five years. This payment is just one monthly payment based on your income and expenses paid to your creditors. Once this period is up, your debts are considered settled.
- Debt consolidation: This method of debt relief consolidates your unsecured debt and lets you pay off your creditors with a personal loan. Over time, you will have one single (ideally low-interest) loan instead of many debts with different payment dates and interest rates.
- Secured loan: You have the option of taking out a secure loan, which is backed by collateral like your car or other valuable personal property. This is riskier than an unsecured loan since lenders may collect your property if you default on your payments.
- Negotiation: You can try negotiating your debts yourself with your creditors. Although this isn't as effective as hiring a debt settlement company, it is an option you may want to explore before going through with hiring a company.
How Do I Pick The Right Debt Settlement Company?
If you ultimately decide to pursue debt settlement, you can narrow down your search by looking for a few key criteria:
- Make sure the debt settlement company is licensed to do business in your state.
- Check to see if it is FTC compliant. Companies are required to follow FTC guidelines and regulations.
- Find out the required minimum debt. Most companies require a minimum of $5,000 to $10,000 to enroll in their services.
- Transparency is key. Companies that are upfront about their services and pricing are more likely to provide better services.
- Check the company's fees for settlement. Most companies range between 15% to 20% of your total enrolled debt or around 30% of your negotiated debt. If their website doesn't offer the information, you can call for a free consultation and talk with a representative to learn more about the fees.
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