What is debt settlement?

Debt settlement means that you settle your debts for less than the full amount owed. In most cases, you offer a lump-sum settlement to the creditor that’s a percentage of what you owe. They agree to discharge the remaining balance in exchange for the settlement payment. This causes a negative item in your credit report for each debt settled, that remains for 7 years from the date of final discharge.

Does debt settlement really work?

In general, a settlement offer must be for at least 50% of what you owe in order for the creditor to agree. However, that’s just a general rule of thumb. There is no guarantee that a creditor will accept a settlement agreement and results can vary widely. As such, this solution should really only be used as a last-ditch effort to avoid bankruptcy.

How does a debt settlement program work?

In most cases a borrower doesn’t just have the money for a lump-sum settlement lying around. A borrower may also have trouble negotiating a settlement offer on their own. As a result, many people usually hire a settlement company to run a debt settlement program on their behalf. Here is how that program works:

  1. You stop making payments to your creditor or creditors.
  2. Instead the money you would be paying gets diverted into a settlement account.
  3. After you have enough funds in that account, the company makes a settlement offer to the creditor, agreeing that you’ll make a lump sum payment that covers a certain percentage of the total amount you owe on that debt.
  4. When the offer is accepted, you make the payment to the creditor and they discharge the remaining balance on your debt.
  5. Once at least one of your debts has been settled, you will be expected to pay a fee to the settlement company for each debt they settle on your behalf – by law, at least one debt must be settled successfully before any fees can be charged.
  6. You will incur a 7-year credit penalty for each debt settled that remains on your profile until 7 years from the date of final discharge. The missed payments will also be noted on your credit report.

When debt settlement is worth the credit damage

As you can see from what’s described above, the credit damage caused by a debt settlement program can be significant. So this solution should not be used if you are trying to avoid further damage to your credit score.

A debt settlement program is best used when you’ve effectively hit rock bottom with your credit already. If your credit is already on the floor in the 500s, then it can’t really fall much farther. As a result, the impact of a settlement agreement will be less severe than it would if you are still holding on to a decent credit score.

Words of warning about debt settlement scams

Credit damage is not the only concern you can have when using a debt settlement program. There is also a high potential for getting scammed. As stated above, by law a debt settlement company must settle at least one debt successfully in order to charge any fees.

However, many companies violate this regulation and charge fees upfront. There is also the possibility that you pay into the settlement account they’re holding for you, and then the settlement company closes. You’re left with debts that haven’t been paid and are in severe default without the funds you’ve built up to make a settlement.