How (and when) debt settlement works

Making the decision to settle a debt for less than you owe.

Debt settlement

In an ideal world when you have too much credit card debt, you find a solution that allows you to pay back everything you owe so you can minimize any credit damage.

Unfortunately, eventually anyone can reach a point where your debt-to-income ratio is so high that you can’t possibly pay back everything you owe in a reasonable amount of time – if ever! In addition, if your debts are too far gone and are in default, some solutions may not even be available.

You can go through bankruptcy, but if you have assets to protect then that may not be the best option. You may also want avoid going back to Square One. In this case, the only option really left is to make a debt settlement offer to one or more of your creditors.

What is debt settlement?

Debt settlement is where you work with a creditor to settle a credit card debt for less than the full amount owed. The idea is that at a point of severe default, a creditor or collector may be willing to accept at least a partial payment to recoup some of their losses even if they can’t get the full amount.

This is a legitimate option for debt relief. On the other hand, there are plenty of debt settlement scams, so you need to make sure you’re taking a real path to settling your debts instead of going down the road to even more problems.

Fact: Be careful! The FTC ranks debt settlement scams as one of the Top 15 most common consumer fraud tactics

Finding legitimate debt settlement

Debt settlement can take a few different paths. The first choice to make is whether you want to attempt settlement on your own or if you want to work with a company. There are distinct advantages to professional help, although you have to be extremely careful when you choose who to work with.

Even so a good, above-the-board debt settlement company can provide the help you need:

  • They have established relationships with creditors.
  • They may be able to include your settlement offer to a creditor with those of other customers; creditors can be more likely to accept collective offers.
  • They are more aware of credit and delinquency trends that can impact a successful settlement.
  • Having a professional evens the playing field during creditor negotiation.
  • The debt settlement companies handle all the paperwork, so there is less stress and hassle on you.

If you decide to work with a company, do your research carefully. Check with the Better Business Bureau to see how the company rates, review any complaints, and see if any government action has be taken from a state or federal Attorney General’s office. Also check a few independent third-party review websites.

In addition, don’t make a decision until you have talked to a representative. Avoid using anyone who charges any nonrefundable upfront fees. If your creditors reject the offer, you will still be on the hook for the debt, your credit will be ruined, and you’ll be out those fees.

When the debt settlement process works

Debt settlement usually only works when you’re behind. If you’re current with your payments, there’s really no reason the creditor would accept a partial settlement offer. So you really have to be at least a few months behind for debt settlement to work – usually more.

Once you begin the process, there are basically two types of settlement offers you can make. In both cases, you are offering to settle your debts for less than you owe, but they differ in how that money is delivered:

  1. A one-time lump-sum payment
  2. A payment plan

The first option is usually more successful, because most creditors feel if you can commit to paying something over a period of time, you should be able to pay back what you owe even on a defaulted debt. Typically the only circumstance where a creditor will accept payments over a period is when it makes sense to break the payments up over a short time span.

Fact: An FTC study found less than 10% of consumers who try a debt settlement program complete it successfully.

For example, if you owe $15,000 to a creditor and offer a $6,000 settlement, the creditor may be willing to accept that settlement in $1,000 installments over a six (6) month period. Outside of this kind of arrangement, there is very little incentive for a creditor to accept a long-term payment arrangement to forgive 40-60 percent of the balance owed.

A best case scenario for settlement is when you already have the money available to make the offer. If you get money from a court judgment, the sale of an asset, or some other kind of windfall, then you can use that money to settle you debts. But in most cases, people aren’t that lucky.

So most with lump-sum settlements, you have to save up in order to make your settlement offer. Many debt settlement companies will recommend you stop paying your monthly credit card bills so you can build up money for the settlement. This is where debt settlement can get risky.

You are basically ruining your credit and working under the assumption that your creditor will accept your offer. If they don’t accept it, your credit will have taken a huge hit and you’ll end up in bankruptcy court, which causes even more credit penalties. It can work, but you need to be aware of the risks before you decide to use this kind of strategy.

Pop Quiz

How long does the penalty for settling a debt remain on your credit report?

a) 3 years

b) 7 years

c) 10 years

d) 15 years

Reveal Answer

This is the same amount of time on a Chapter 13 bankruptcy penalty.

b) 7 years

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