What is debt settlement and how does the process work?

You’ve probably heard the term “debt settlement” thrown around, especially if you or someone you know is dealing with debt. But what exactly is a debt settlement program, and how does it work? In this article, we’ll demystify this financial strategy that could help you or your loved ones become debt free.

What types of debts can be settled?

Before we get into the nitty-gritty, it’s important to know which types of debt can actually be settled. Typically, unsecured debts are the main candidates for settlement. These include:

• Credit card debt

• Personal loans

• Medical bills

• Private student loans

Secured debts like mortgages or car loans usually can’t be settled because they’re backed by an asset. That means the lender can take away the asset if the debtor stops making payments.

Benefits of debt settlement

Now, let’s talk about the good stuff. Debt settlement can offer many attractive benefits:

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• Potentially pay less than you owe: The main draw of your debt settlement is the possibility of paying less than your full debt amount.

• Become debt-free faster: By negotiating a lower payoff amount, you might be able to clear your debts more quickly.

• Avoid bankruptcy: For some, debt settlement can be a last resort before considering bankruptcy.

Risks of debt settlement

But hold on — it’s not all smooth sailing. The debt settlement process comes with its fair share of consequences and risks:

• Credit score impact: Your credit score may take a hit during the process.

• No guarantee of success: There’s no guarantee that your creditors will agree to settle.

• Potential legal actions: Creditors might decide to sue you for the unpaid debt.

Difference between professional debt settlement companies and DIY debt settlement

You’ve got two main options when it comes to debt settlement: 

• Professional debt settlement companies: They handle all negotiations on your behalf and may have established relationships with creditors, helping you obtain better terms. However, they also charge a fee for their service.

• DIY debt settlement: You negotiate directly with creditors, which can be more challenging, but you don’t have to pay any extra fees.

Alternatives to debt settlement

Before jumping on a debt settlement plan, it’s worth considering alternatives:

• Credit counseling: This involves working with a financial expert to create a debt management plan. They can help you understand your financial situation and explore options for debt relief.

• Debt consolidation: This involves taking out a new loan to pay off multiple debts. It can simplify your monthly payments and save you money on interest.

Fees associated with debt settlement

If you decide to work with a debt settlement company, be prepared for fees. They usually range from 15% to 25% of the settled debt amount. Always ask about fees upfront and make sure you understand what you’re paying for.

Choosing a reputable debt settlement company

If you do opt for professional help, it's a good idea to do your homework:

1. Check for accreditation with organizations like the American Association for Debt Resolution (AADR).

2. Read reviews and check the company’s rating with the Better Business Bureau.

3. Be wary of companies that promise to settle your debt for pennies on the dollar.

4. Avoid any company that asks for fees before settling your debts. 

Impact of debt settlement on credit scores

Debt settlement will likely affect your credit score in the short term. Settled debts are usually reported as “settled for less than the full balance,” which can negatively impact your credit. However, if you’re already behind on payments, the impact may not be as severe.

Potential tax implications

Here’s something many people don’t realize: Forgiven debt can be considered taxable income by the IRS. This means you might owe taxes on the amount of debt that was forgiven. It helps to consult with a tax professional to understand the implications of your specific situation.

FAQs about debt consolidation

What is debt settlement and how does it work?

Debt settlement is a process in which you negotiate with creditors to pay off your debt for less than what you owe. You typically stop making payments to your creditors and instead, save money in a separate account. Once you’ve saved enough, the negotiation process begins. Once you and your creditor reach terms, you’ll sign a debt settlement agreement, which outlines important details of your settlement.

Is debt settlement a good option?

It depends on your financial situation. If you’re struggling with unsecured debt and have exhausted other options, debt settlement might be worth considering. However, it’s not without its risks and should be carefully weighed against alternatives.

What happens after debt settlement?

After successful settlement, the creditor will mark your account as settled, and you’ll no longer owe the debt. However, this will be reflected on your credit report and may impact your ability to get credit in the short run.

What are the negatives of debt settlement?

The main drawbacks include potential damage to your credit score, the possibility of being sued by creditors, and potential tax implications on forgiven debt.

What is a settlement offer from a debt collector?

A settlement offer from a debt collector is typically a proposal to resolve your debt for less than the full amount owed.

Considerations before going for a debt settlement

Before you go all-in on debt settlement, here are some questions to consider:

1. Have I explored all other options?

2. Can I commit to the process, which might take two to four years?

3. Am I prepared for the potential impact on my credit score?

4. Have I considered the tax implications?

5. If using a company, have I thoroughly researched its reputation?

Remember, while debt settlement can be a path to becoming debt free, it’s not a decision to be taken lightly. It's a good idea to consult with a financial advisor if possible.

Teaching your kids about managing money and avoiding too much debt is crucial. Consider using a money and safety app for families like Greenlight to help your kids learn about budgeting and smart spending from an early age. By instilling good financial habits now, you can help kids avoid the need for debt settlement in the future.