When struggling to pay off debt, especially a high amount, it’s not uncommon to come across companies offering debt consolidation. However, many for-profit companies offering “consolidation” are actually selling a debt settlement service.
Debt settlement is where a third-party company can try to reduce someone’s debt by negotiating with their creditors or debt collectors on their behalf. While some debt settlement companies might be successful in lowering the amount of debt, these programs can be risky because of how they are structured.
Paying off less debt might sound like an easy win, but debt settlement can come with some big financial risks, possibly affecting the debtor’s credit score and ability to access credit in the future, and costing more along the way.
What Is Debt Settlement and How Does It Work?
Debt settlement is an agreement with a creditor to pay less than the total amount owed. It’s sometimes referred to as “debt relief” or “debt adjustment.”
Typically, a debt settlement program focuses on unsecured debts, which aren’t tied to a physical asset like a house or car. Examples of this include credit cards, store cards, personal loans, and medical bills. Other types of debt, such as mortgages, car loans, student loans, and tax debt, usually don’t qualify for these programs.
While debt settlement might provide some relief for debtors who are at the end of their financial rope, it’s by no means a simple solution. The process may take years, could require you to pay high fees, and can damage your credit score. Plus, it won’t wipe out all of your debts.
Though it’s a potential alternative to bankruptcy, it should be considered as a last resort.
💡 Quick Tip: A low-interest personal loan from SoFi can help you consolidate your debts, lower your monthly payments, and get you out of debt sooner.
How Debt Settlement Works
How does debt relief work? Let’s take a look.
You can negotiate a debt settlement on your own. If you decide to go this route, start by contacting each creditor and confirming whether you owe the debt. If you do, determine a realistic payment plan, and propose it to the creditor. During the negotiating process, you’ll continue to make regular payments on what you owe.
However, the debt settlement process can be confusing and could take years to complete. You might decide to enlist the help of a trusted third party, like a debt settlement company, to negotiate on your behalf.
During the negotiation process, you may be required to enter a debt settlement program. These programs typically encourage debtors to stop paying creditors and instead make monthly payments into a savings account. Once a settlement is reached, the company may take its fees out of that account first and use the balance to pay off the debt.
It’s important to note that if you choose to stop paying creditors, your credit score may be negatively impacted and you could face late fees and penalties.
What Do Debt Relief Companies Do?
The goal of debt settlement companies, also known as debt relief companies, is to work with people to get a better payment plan to help reduce debt. They typically charge fees for these services, usually between 15% to 25% of the total enrolled debt. However, you should only be charged once your debts have been settled or resolved.
Debt relief companies often require an initial consultation so they can determine whether you qualify for their debt relief program and which option might fit your situation. You also might be asked to provide basic information regarding your current creditors, debt balances, monthly income, and expenses.
Once you enroll in a debt relief program, you’ll probably be required to make monthly payments into a bank account that you’ll control. Typically, the debt settlement company will negotiate with a creditor once the account contains enough money for them to make a lump-sum offer.
In the meantime, the company may also advise you to stop paying your creditors. Note that doing so may cause your account(s) to flow further into delinquency or even charge-off, which can cause significant harm to your credit health and your ability to access credit in the near and long term.
Why Is Debt Settlement Risky?
Though debt settlement can be a viable alternative to bankruptcy, it has drawbacks. Here are risks to keep in mind:
Debt Settlement Can Be Expensive
By law, a debt relief company can’t charge you any fees until after they settle or reduce at least one of your debts. And you won’t have to pay if a creditor flat-out refuses your settlement. But once a debt is lowered or settled, you’ll likely incur charges that, when added up, could end up being more than what you originally owed.
What’s more, you may have to pay taxes on any debt that’s been forgiven, as the IRS considers that as income. Consider talking to a tax professional about any tax repercussions you may face if you settle your debt.
Debt Settlement Can Damage Your Credit
If you stop paying your creditors, you may be hit with late fees, penalty payments, higher interest charges, and other fees that can increase your overall debt. Late or missed payments can also be reported to the credit bureaus, and your credit score will likely be seriously damaged.
Something else to keep in mind: Though not as serious as bankruptcy, settled accounts are generally seen as negative events in credit history and can stay on credit reports for up to seven years.
There’s No Guarantee Debt Settlement Will Work
Creditors are under no obligation to accept a settlement proposal, and not all creditors will negotiate with a debt relief company. If your settlement is rejected, you may want to consider creating a debt management plan and start making payments.
How Does Debt Settlement Affect Your Credit Scores?
When you’re trying to settle a debt, your credit scores can take a hit. Late or missed payments, being sent to a collection agency, and even a settled account can all have a negative impact on your credit scores for years afterward.
What’s more, if you try to settle a debt and fail — and you have no other options — you may end up considering bankruptcy as a solution. Depending on the type of bankruptcy settlement you choose to file, it could stay on your credit report for seven to 10 years. It may also make it difficult to get credit, buy a home, or in some cases, get hired for a job.
How Is Debt Relief Different From Debt Consolidation?
Though these two debt payoff strategies sound similar, debt relief and debt consolidation work differently.
With debt consolidation, you take out a loan or line of credit and use it to pay off other debts. Once you consolidate those existing loans into a single loan, you have just one predictable, monthly payment and one (hopefully better) interest rate. Consolidation can help make budgeting and bill paying easier, and if you’re able to secure a lower interest rate, you may even save money by reducing how much interest you pay over time.
Debt settlement, on the other hand, involves negotiating the terms of your debt with your creditor so you end up paying less than what you owe, usually in one lump sum.
What Are the Pros and Cons of Working With a Debt Settlement Company?
Before jumping into debt settlement, there are some pros and cons a debtor might want to consider first. On the plus side, that anxiety about answering phone calls for fear a collection agency is on the line could go away.
In addition, all those debts could be consolidated into a single bill, so the debtor wouldn’t have to pay numerous bills a month on debt. And, of course, debt settlement could reduce debt long term and help avoid bankruptcy.
However, there are some potential negative financial implications:
• Debt settlement companies typically encourage those who enroll in their services to stop sending payments to creditors during the negotiation period. This can seriously affect credit scores, incur late fees, and build up interest, actually digging a deeper hole. Creditors can also sue for repayment even when a debtor is working with a debt settlement company, and can take money directly from someone’s wages or force repayment in other ways.
• Creditors are not under any obligation to work with debt settlement companies. Even saving the monthly amount the programs require is no guarantee the two parties will be able to settle some of the debts.
• Debt settlement companies could still charge fees even if the entire debt wasn’t settled. While debt settlement agencies cannot charge fees until a settlement is reached, and at least one payment is made as part of the agreement, each time they successfully settle a debt with one creditor, the company can charge another portion of its full fee.
Beware of Debt Settlement Scams
Before deciding to enroll in a debt settlement program, it’s important to check the company with the local state attorney general and local consumer protection agency . These agencies can help determine if there are any customer complaints on file about the debt settlement company.
Also, a quick internet search of the company name and “complaints” could reveal any current lawsuits or deceptive and unfair practices. One easy method to find the top debt settlement companies is to look for those with good grades from the Better Business Bureau.
Some common red flags when researching any company promising to settle debt:
• Charging any fees before settling any debt. This is prohibited by the FTC’s Telemarketing Sales Rule.
• Promising to settle all debt for a specific percentage. Debt settlement companies cannot guarantee the amount of money or percentage of debt that could be saved by using their services. They also can’t guarantee how long the process will take.
• Claiming there is a “new government program” that they are assisting with
• Guaranteeing to eliminate debt entirely
• Explicitly giving instructions to stop communications with creditors, and not explaining the serious financial consequences of doing so
• Saying they can stop all debt collection calls or lawsuits
• Starting enrollment without any review of an individual’s financial situation
The FTC advises people to avoid any sort of organization, whether they are offering credit counseling, debt settlement, or any other financial service, that fails to explain the risks associated with their programs, makes grandiose promises, and asks for any money upfront.
Debt Settlement Alternatives
In contrast to some debt settlement companies that are profit-driven, reputable credit counseling organizations might be available to offer help with managing money and debts, developing a budget, and providing free educational tools and workshops.
Counselors should be certified and trained and help develop an individual plan for solving money problems. One place to start could be this list of nonprofit agencies certified by the Justice Department, which offer counseling and debt management plans.
Credit counselors might suggest a debt management plan, where one monthly payment is made to the credit counseling organization, and then they make all of the individual monthly payments to creditors. Counselors do not typically negotiate any reduction in debts owed, but could help lower monthly payments by working to increase the loan terms or lower interest rates.
Talking to Creditors
A debtor could take the DIY approach and talk to the creditor personally, even if negotiations for a lower rate or debt reduction have not worked in the past. Instead of paying a company to talk to a credit card company or other debt creditor on their behalf, remember that anyone can do it themselves for free.
The conversation could be approached with the goal of figuring out a modified payment plan to reduce payments to a manageable level.
Creditors and their collection agencies are typically willing to negotiate, even if they have already written off a debt as a loss.
According to the Consumer Financial Protection Bureau, many creditors and debt collectors will not negotiate how much they are willing to settle for, meaning debt settlement companies likely can’t get better terms than an individual could get by talking to the creditors themselves.
A balance transfer could also help when it comes to consolidating credit card debt.
A balance transfer is when someone moves debt from one credit card to another, usually taking advantage of a 0% interest offer on the newer card. While the 0% rate only lasts for a specific amount of time, this offers the opportunity to pay off more of the credit card debt during that promotional period since new interest isn’t accruing.
💡 Quick Tip: If you’ve got high-interest credit card debt, a personal loan is one way to get control of it. But you’ll want to make sure the loan’s interest rate is much lower than the credit cards’ rates — and that you can make the monthly payments.
Fixed-Rate Personal Loan
Rather than looking to a debt settlement company to fix high debt, another alternative that could be considered is a fixed-rate personal loan, which might be easier to manage and could help save money in the long run. By consolidating qualifying high-interest debt into one low-interest personal loan, a borrower could simplify by only having one fixed monthly payment.
In certain situations, debt relief programs can be a viable alternative to bankruptcy — and for some, a debt solution that provides some relief. But in general, they’re seen as a last resort for those at the end of their financial rope. The process may take a long time and often involves paying high fees, which could bite into any savings you would have received from a settlement. And if you decide to stop paying your creditors and instead pay into a savings account, you may incur penalties, and your credit score will likely be damaged. There are alternatives to debt relief programs that may be worth considering, including negotiating with creditors yourself, credit counseling, and balance transfers.
Think twice before turning to high-interest credit cards. Consider a SoFi personal loan instead. SoFi offers competitive fixed rates and same-day funding. Checking your rate takes just a minute.
SoFi’s Personal Loan was named NerdWallet’s 2023 winner for Best Online Personal Loan overall.
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