Everything you Need to Know About Debt Settlement
The debt relief industry is vast and varied, with options for consolidation, refinancing, and even forgiveness. All these options provide an escape route, the light at the end of a very dark tunnel. One of the most effective is debt settlement, but this option isn’t for everyone and if you’re not careful it can make your difficult financial situation even worse.
If you have mounting credit card debt and other unsecured debt, there’s a good chance you’ve come across debt settlement before. But what is it, how can it help you, what are the fees involved, and what do you need to know before you begin?
How the Debt Settlement Process Works
The goal of debt settlement is to “settle” your debts for less than their current balance. It works on credit card debt and personal loans but is effective at clearing all unsecured debts.
The process typically begins with a consultation, something that most debt settlement companies provide free of charge. If you’re a good fit for the program, they’ll discuss the terms with you and invite you to make regular payments to a secure third-party account.
A debt specialist will then contact your creditors and negotiate a reduced settlement on your debts. They’ll use the account to pay those settlements and will only take their fee (based on a percentage of the original debt or the settled amount) once this process has been finalized.
In many cases, accounts are settled with debt collectors and not the original creditor, as debt settlement works best for borrowers who have multiple missed payments, collections, and other issues. This is when debt settlement is most effective because there is a very real risk that the debt will never be repaid.
Why Would Creditors Settle?
If you’re new to debt settlement, all this might seem a little strange. Why would a creditor agree to settle a debt for a lump-sum payment that’s 40% to 90% of the original balance? Why would a settlement offer of just a few thousand be accepted on a credit card debt of $15,000 or $20,000?
To understand this, you need to see things from the creditor’s perspective. If a borrower misses several payments, the lender will try to create a payment plan or negotiate a deal. If that fails, the debt is sold to a collection agency, often for just a few cents on the dollar.
Collection agencies may pay as little as $500 for a debt of $10,000, which means they have a very large profit margin. If a debt specialist calls the creditor and offers $5,000 for a debt they’ll soon be forced to sell for $500, they’ll be happy to agree. Likewise, if they contact a collection agency offering a few thousand dollars for a debt they recently bought for a few hundred, why would they say no?
In that sense, a debt settlement program is somewhat of a win-win—you clear the debt, your creditors recover more money, and the settlement company gets paid. However, it’s not always that straightforward as we’ll soon discover.
How Long Does It Take to Settle your Debts?
Debt settlement companies don’t work quickly, because creditors aren’t interested in IOUs and debtors need time to cover the settlement fees. If you have recently come into a lot of money and can put that towards the debt settlement program, this process could be completed in just a few months. You could even do it yourself. However, if you’re steadily accumulating that money by tightening your belt and skipping monthly payments, it can take up to 4 years.
Debt Settlement vs Debt Consolidation and Debt Management
The only real similarity between a debt settlement plan and a debt management plan is that they can both help you escape your debts. A debt management program is often conducted by a nonprofit agency and works by consolidating your debt, canceling all but one emergency credit card, and swapping multiple payments and fees for a single payment.
A debt consolidation loan works in much the same way, but without the requirement that you cancel multiple cards and accounts. Both debt consolidation and debt management decrease your monthly payments and interest but prolong the length of your loan, which means you pay less per month but more over the term.
Debt settlement, on the other hand, focuses on settling your debts quickly and cheaply. You will need to find more money in the short-term, but it will save you much more in the long-term.
The way that these programs impact your credit score is also vastly different. Debt management and consolidation have a minimal effect, while debt settlement can feel like a financial cluster bomb has just landed in your report.
How Debt Settlement Affects Your Credit
All forms of debt relief will impact your credit score in one way or another, but this impact varies, from the relatively gentle impact of debt consolidation to the catastrophic one of bankruptcy. Unfortunately, while it does have its positives and can be a great way to quickly repay what you owe, debt settlement can also have a hugely negative effect on your credit score.
What Happens to Your Credit Score when you Settle a Debt?
All settled debts will show as “Settled” on your credit report. This has less of an impact on your score as an “Unpaid” status but is not as positive as a “Paid in Full”. There is a logic behind this: Creditors prefer applicants who make all payments and repay the full balance over those missing payments and trying to settle.
FICO and VantageScore, the two leading credit scoring systems, have not released details concerning how much a settled status will impact your score. However, they have created hypothetical situations and suggested that it can reduce an individual’s score by between 50 and 150 points depending on how high it was to begin with.
How It Improves your Credit Score
Debt settlement won’t improve your score in the short-term. In fact, it may take years before your score begins to improve. If you have multiple derogatory marks and no money saved, the settlement process could take 4 or 5 years and, in that time, you’ll struggle to maintain a respectable score. Once all accounts have been settled, you may need to wait a few years before you can build towards a Very Good or Exceptional score.
However, the good news is that you won’t have all those debts, penalty fees, and high-interest rates to worry about. You will also see a slight improvement once those accounts clear and this will get better with each passing year as they age.
The bad news is that you may struggle for a few years and will need to carefully rebuild your credit after that. The good news is that you’ll have more money in your pocket, fewer debts to worry about, and all the time you need to rebuild.
How Long Does It Stay on your Credit Report?
A settled account will remain on your credit report for 7 years from the date that the account first became delinquent. This 7-year rule applies to most derogatory marks, apart from bankruptcy, which can remain for up to 10 years.
Debt Settlement Options
Still not sure if debt settlement is for you or if you should opt for a simpler method like debt consolidation instead? Keep the following in mind:
When is Debt Settlement the Best Choice for Debt Relief?
Debt settlement is more effective for borrowers who have defaulted on numerous debts and have a lot of missed payments and collections. If these have been active for several years, even better—your credit score will be low, your credit report will be a mess, and you’ll be in prime position for debt settlement.
Not only will the debt specialist have an easier time negotiating reduced settlements, but you’ll see less of an impact on your credit score. It also works really well for individuals with lots of credit card debt and personal loan debt.
It’s worth noting, however, that if your debts are over 4 years old they may have passed their statute of limitations, in which case you’re no longer responsible for them. Check your state laws to discover the statute of limitations on unsecured debt and better understand your options.
When is Debt Settlement the Wrong Option?
If you have a couple of large debts on a relatively clean account and you’re just looking to save some money, debt settlement is not for you. If your credit score is above 700 then you’re in prime position if you ever want a home loan, mortgage, or low-interest credit card. By intentionally missing payments and seeking to settle accounts, you could see your score drop below 500 in a few months and this will seriously impact your financial health.
The idea of offering your creditors a massively reduced lump sum to settle an account is very appealing. However, it should only be considered as a last resort by consumers who have more debt than they can handle and are being refused options like debt consolidation, debt management, and refinancing.
How to Find Legitimate Debt Settlement Companies
All debt settlement companies are required to abide by strict rules and regulations. For example, they can’t legally charge you until all debts have been settled. However, the way these companies operate can vary greatly from one company to the next so don’t sign-up with the first one you find and do a little research before you commit:
- Look for Accreditations: The best companies are listed on the Better Business Bureau and have accreditations from organizations such as the IAPDA and AFCC.
- Read Reviews: If a company persistently fails to meet expectations then their customers will let their frustrations be known. A few bad reviews are common—you can’t please everyone. But it’s bad news when bad reviews start to outnumber good ones.
- Fees: Ask them how much they charge and how much they can save you. Be wary of any company that guarantees to settle your debts for a specific sum—this is not a promise that a legitimate company will make.
- Check Settlement Amounts: Look for proof of average settlements and compare this information across multiple companies, focusing on success stories that are genuine and similar to yours as opposed to cherry-picked, generic testimonials.
- Be Wary of Pressure Selling: Take advantage of their free consultation, but hang-up if they begin pressure selling and are clearly not interested in providing genuinely helpful advice.
Pros and Cons of Debt Settlement
Not sure if debt settlement is right for you? Take a look at these pros and cons to better understand the positives and negatives.
How Can you Benefit from Debt Settlement?
There are some huge downsides to debt settlement and we’ll get to those shortly, but for the most part, this is a very effective way for millions of Americans to clear debt.
You’ll Pay Much Less
If you meet monthly payments on a credit card debt of $10,000, you could pay upwards of $15,000 over the lifetime of that debt, assuming there are no major penalties or fees. If you get a debt consolidation loan, that may increase to $20,000 or more, depending on the size, length, and interest rate, while a balance transfer could add just a few hundred onto the original balance.
With a credit card debt settlement program, however, it could be reduced to $5,000 or less and even when you add the company’s fees you’ll still save several thousand on the original balance. Besides bankruptcy, there is no other debt relief program that can have that kind of impact and that’s what makes debt settlement so unique.
Debt settlement companies generally provide a free consultation in the first instance and if you work with a genuine, legitimate company, they won’t pressure sell and will always seek to provide you with genuinely helpful advice. If you’re in the dark with regards to debt and debt relief, this can be a huge help.
You’ll get a Clean Slate
Once your debts have been settled and the impact on your credit report has lessened, you’ll have a clean slate on which you can rebuild your credit. Debt settlement may be destructive, but the same could be said for an account that has masses of debt, missed payments, and collections, and at least debt settlement provides a solution and an escape.
What are the Negative Effects?
The best debt settlement companies will warn you about the potential downsides and advise you against them. But some companies will gloss over these issues and focus only on the positives, so make sure you keep all of the following in mind:
Reduced Credit Score and Late Fees
Debt settlement works best when you have multiple missed payments and collections on your account. If you don’t have any of these but have substantial debts, debt settlement companies may recommend that you stop making payments and start putting that money towards your settlements instead.
This will accelerate the settlement process and make the specialist’s job easier, but it will also trigger a catalog of derogatory marks on your credit report as all that information will be passed to the credit bureaus. Your score will also take a hit every time an account is settled, although this has less of an impact the lower your score is, and its impact will reduce over time.
Risk of Lawsuits
Creditors don’t hang onto debts for long and often sell them after just a few months. Collection agencies will hassle the borrower after purchasing the debt, but they’ll give up eventually if they can’t get what they want.
However, if you owe a lot or come up against a persistent collector or creditor, they may take legal action. They can get a judgment against you that turns all that unsecured debt into secured debt and can lead to asset seizures and wage garnishing.
It’s a Long Process
Debt settlement can drag on for several years and you may struggle to maintain a respectable credit score in that time.
This can make it difficult for you to get a new loan or credit card and will pretty much rule out the possibility of acquiring a home loan or car loan. If you settle numerous accounts then you may struggle to get a large loan for years to come, but every month that passes reduces the impact that a settled account has on your score and within a few years it will be negligible.
Summary: A Viable Option for Some
Debt settlement companies like National Debt Relief help to clear billions in consumer debt every single year. This forgiven debt gives collectors and creditors a little more money than they would otherwise have; it gives borrowers the escape they’re desperate for and it helps to fund an industry built on good intentions.
That doesn’t mean it’s perfect—there are scam debt settlement companies out there and there are also companies that just don’t care enough to get the best results. It’s also not for everyone and, in some cases, it can do more harm than good. But for millions of consumers struggling with vast quantities of debt and derogatory marks, it could be the only way to avoid the threat of bankruptcy and get back into the black.