Editorial Policy

How to know if debt settlement is right for you

Allie Johnson

By
November 17, 2014

If you're struggling to make credit card payments, debt settlement might sound like a quick fix. But while it may work for some, it's no easy cure.

“Debt settlement is an aggressive strategy for debt reduction,” says Charles Phelan, founder of ZipDebt.com, which offers tools and coaching to help consumers settle their own debts. “But, it's not for everyone.”

Essentially, debt settlement is making a deal with a creditor who agrees to take less than the total you owe as full payment of the debt. It is an option to consider after all others fail. Before you pursue debt settlement, you need to look at selling items and cutting costs.

Still feel debt settlement is the answer? There are two ways to approach it: Use a debt settlement company or try to settle your own debts.

Considering going with the first option? “You need to be very, very careful,” says Ira Rheingold, executive director of the National Association of Consumer Advocates, a nonprofit association of consumer attorneys and advocates. Some debt settlement companies make promises they can't keep and charge hefty fees, he says, adding that consumers can end up even deeper in debt. Debt settlement companies don't do anything a consumer can't do on his or her own for less money, Phelan says.

How debt settlement works

Here's how the settlement process typically works:

1. Once you default on an account, which means you stop making payments as agreed, collection calls begin, he says. Let the calls go to voicemail, but call your creditors regularly to discuss your financial hardship, Phelan recommends.

2. After six months, most banks are willing to talk about settling, he says. At that point, you can make an offer. “Then it's just good, old-fashioned haggling,” Phelan says. Settlement figures can range from 20 to 50 percent or more, depending on the creditor.

3. Always get the agreement in writing before paying off the creditor, Phelan says. After you pay, check your credit reports to make sure the account shows a zero balance.

4. A settled debt is reported on your credit with a note stating it has been settled for less than the amount owed, which is considered a negative, according to Experian, one of the three major credit bureaus. Delinquencies on the account stay on your credit for seven years.

“Your credit is going to go in the tank,” Phelan says, adding that the credit impact of debt settlement is similar to bankruptcy. “And it takes a while to recover.”

Is debt settlement an option for you?

Debt settlement hurts your credit, isn't easy and carries risks. But experts say settlement might be a viable choice if you:

  • Can't afford bill payments. Settlement is an option for someone experiencing serious financial hardship who is behind on bills or will default in the near future, Phelan says. However, it's worth noting that many lenders will not broach settlement talks until you default on payments.
  • Have considered bankruptcy. A consumer struggling with debt might look into the possibility of bankruptcy. In Chapter 7 bankruptcy, many debts, including credit card debts (but not student loans) can be wiped away, Rheingold says: “Sometimes it makes sense to start fresh.” However, for consumers who don't qualify for Chapter 7, possibly because they make too much money, settlement can be “a good Plan A,” Phelan says.
  • Looked at other solutions. One good way to get help is through a nonprofit credit counseling agency, Rheingold says. A counselor can review your debts and budget and might be able to arrange a debt management plan, with negotiated lower payments and interest rates on your accounts. But, a word of caution: “If you get into a debt management plan and start missing payments, things are just going to get worse,” Rheingold says.
  • Can come up with cash to settle quickly. It's important to settle debts within about a year, and to tackle all accounts at the same time, says Jared Strauss, who owns a small debt settlement company, Debt Relief a la Carte. So, only consider debt settlement if you can fairly quickly come up with the funds to pay off about 40 percent of your debts at once. The settlement money can come partly from saving up any extra cash you have after paying for basic living expenses, while the rest might come from a loan from a family member or sale of an asset.

Before deciding to go the debt settlement route, consider possible downsides, experts recommend.

For example, you might get sued by creditors while you're in the process of trying to settle your debts, especially if you drag the process out, Phelan says. If you take years to try to settle, “you're just setting yourself up for multiple lawsuits.”

That's because, as time goes by, the chances of collecting by phone decrease dramatically, he says. After a year to a year and a half, the creditor might assign the debt to a law firm in the debtor's state. “The law firm will eventually get around to filing a lawsuit,” Phelan says, if they're authorized to do so.  Or, as time goes by, the debt might get sold to a debt buyer for pennies on the dollar, he says: “Some purchasers just routinely sue on every file they buy.”

Also, you might have to pay taxes on forgiven debt, says Ed Boltz, president at the National Association of Consumer Bankruptcy Attorneys. For example, if you settled $10,000 worth of debt for $7,500, the creditor will report to the IRS that you had $2,500 worth of income.

“People often get blindsided by the taxes,” Boltz says. “They find they've gone from owing Discover to owing the IRS.”