Is Debt Settlement a Good Idea? What You Should Know

Debt settlement is a financial strategy where a debtor and creditor agree to resolve a debt for a reduced amount. This process involves paying a lump sum that is less than the total balance originally owed.

Understanding Debt Settlement

The process commonly begins with the debtor, often through a debt settlement company, ceasing payments to creditors. Funds are accumulated in a dedicated special savings account, sometimes called an escrow account, set up by the debt settlement company.

As these funds build, the debt settlement company negotiates with creditors on the debtor’s behalf. The goal is to convince creditors to accept a reduced lump sum payment, often between 30% to 50% of the original balance. This strategy applies to unsecured debts, such as credit card balances, personal loans, and medical bills, which lack collateral. Secured debts, like mortgages or car loans, are not eligible because they are backed by an asset the lender can repossess. Student loans and tax debts are also excluded from debt settlement.

Financial and Credit Implications

One impact of debt settlement is on the debtor’s credit score, which can be negatively affected. Stopping payments to creditors, a common recommendation during the settlement process, leads to delinquent accounts, late fees, and penalties. These negative activities, including the debt being reported as “settled” or “paid for less than the full balance,” can remain on credit reports for up to seven years from the date of the first missed payment.

The IRS generally considers any canceled or forgiven debt to be taxable income. Creditors must issue Form 1099-C, “Cancellation of Debt,” to both the debtor and the IRS if the forgiven amount is $600 or more. Debtors must report this as income on their federal tax return unless an exclusion applies. A common exclusion is insolvency, where a taxpayer’s total liabilities exceed their assets immediately before the debt cancellation. If a debtor qualifies as insolvent, they may exclude some or all of the canceled debt from their taxable income by completing IRS Form 982 and attaching it to their tax return.

Fees charged by debt settlement companies also contribute to the overall cost, ranging from 15% to 25% of the total enrolled debt, or sometimes the amount saved. These fees are collected only after a settlement has been successfully negotiated.

Ceasing payments to creditors during the debt settlement process can expose debtors to collection efforts, including potential lawsuits. Creditors may pursue legal action to recover the outstanding balance, which could result in a judgment against the debtor. A judgment might lead to wage garnishment, bank account levies, or liens on property, depending on state laws. The risk of such actions persists until a settlement is finalized.

Alternative Debt Relief Options

Debt relief options include:

Debt Management Plan (DMP): Offered by non-profit credit counseling agencies, a DMP involves negotiating with creditors to lower interest rates and consolidate multiple unsecured debts into a single monthly payment. Unlike debt settlement, a DMP aims to pay off the full principal over three to five years and has less severe impact on credit scores.
Debt Consolidation Loan: A new loan is taken out to pay off several existing debts. The goal is to combine multiple payments into one, ideally with a lower interest rate, simplifying repayment and potentially reducing overall interest cost. Eligibility often depends on the borrower’s creditworthiness.
Bankruptcy: This legal process provides debt relief but significantly impacts credit. Chapter 7 bankruptcy involves liquidating non-exempt assets to pay creditors, with most unsecured debts discharged within months. Chapter 13 bankruptcy involves a court-approved repayment plan over three to five years, allowing debtors with regular income to reorganize debts and retain assets. Both types remain on credit reports for seven to ten years.
Direct Negotiation with Creditors: Individuals can negotiate directly with creditors, bypassing debt settlement company fees. Debtors can discuss hardship programs, modified payment plans, or direct settlement offers. Creditors may work with debtors to create a manageable repayment solution, especially if the debtor cannot pay the full amount.

Deciding on Debt Settlement

Debt settlement might be considered if an individual has substantial unsecured debt, like credit card debt or personal loans, and is experiencing financial hardship that prevents full payments. This hardship could stem from events like job loss, medical issues, or divorce. The ability to save a lump sum for the settlement payment is also a practical requirement.

Individuals should assess their comfort level with potential damage to credit scores and the possibility of collection efforts or lawsuits from creditors while the settlement process is ongoing. Understanding the long-term implications of a “settled” status on a credit report, which can last up to seven years, is important for future financial planning.

If engaging with a debt settlement company, thorough due diligence is essential. Inquire about the company’s fee structure, how fees are calculated, and when they are collected. Reputable companies do not charge upfront fees and only collect payment after a debt has been successfully settled. Ask about their success rates in settling debts, the timeline for the process, and how they handle client funds, such as the use of dedicated escrow accounts.