The average American carries a debt balance of nearly $100,000. Fortunately, there are solutions to help manage this debt. Debt consolidation, for instance, involves borrowing money to pay off existing debts, ideally leaving you with a single, manageable payment toward the consolidation loan.

But what if debt consolidation isn’t feasible? If you don’t qualify for a consolidation loan due to a low credit score, debt settlement might be an alternative. Debt settlement involves negotiating with lenders to reduce the total debt amount in exchange for a large lump-sum payment.

How does debt settlement work?

Debt settlement requires the borrower to negotiate a reduced payoff amount with the lender.

For example, if you have $10,000 in credit card debt with high interest rates that seem insurmountable, you might propose a $6,000 settlement to your credit card company. If they agree, you would pay $6,000, and the company would forgive the remaining $4,000.

Creditors are more likely to agree to a settlement if you can pay the agreed amount immediately. Alternatively, you might negotiate a future payment plan, giving you time to save the necessary funds. You would need to convince the credit card company that accepting the settlement is better than risking your default.

Ensure the settlement agreement is in writing. Note that it will likely appear on your credit history and can negatively impact your credit score for up to seven years.

If you have multiple debts, you may need to negotiate separately with each creditor.

Debt settlement only applies to unsecured debt. Mortgages and auto loans, which are secured by property or vehicles, cannot be settled in this way. If you default on secured debts, the lender will likely foreclose or repossess the asset.

Hiring a debt settlement company vs. DIY debt settlement

If settling debt with multiple creditors or debt collection agencies feels overwhelming, you might consider hiring a debt relief company, also known as a debt settlement company, to handle the process for you.

Here’s how it works: you stop paying your creditors and instead make monthly payments to the debt relief company. A portion of these payments is held in an escrow account until there’s enough money for the debt settlement company to offer a lump-sum payment to your creditor(s). The rest of your payments cover the debt settlement company’s fees.

Established debt relief companies have experience negotiating settlements and relationships with major debt collection agencies and creditors. Their insider knowledge, negotiation skills, and connections might help them secure a better deal than you could on your own.

Negotiating debt settlement on your own is challenging because you lack the experience and relationships that settlement companies have. A debt settlement expert could help you save money and get out of debt faster.

Pros and cons of debt settlement

Potential Benefits of Debt Settlement

  • Avoiding Collections or Bankruptcy: Debt settlement should not be your first choice, but it can be a worthwhile option if it helps you avoid having accounts sent to collections or filing for bankruptcy.
  • Relief from Debt: Excessive debt, especially with high interest rates, can be mentally and emotionally draining. Debt settlement can provide relief by reducing the amount owed.
  • Forgiven Debt: If a portion of your debt is forgiven, you can eliminate your debt faster and potentially save money in the long run.

Potential Downsides of Debt Settlement

  • Lower Credit Score: Debt settlement is often noted on your credit report, which can negatively impact your score for up to seven years.
  • Cash Requirement: Creditors usually require a lump-sum payment or a future payment to settle the debt. You’ll need to have the cash available to meet these terms.
  • Tax Obligations: The IRS typically considers forgiven debt as taxable income. For example, if you have $4,000 of credit card debt forgiven, you would need to report that amount as income on your tax return.
  • Account Closures: Creditors often close accounts once they are settled, which means you would lose access to that credit line. Closing the account can also negatively affect your credit score by reducing the age of your average active credit lines and overall available credit.

Steps to negotiating debt settlement

Whether you choose to negotiate a debt settlement on your own or through a debt relief company, the process generally involves six basic steps.

1. Verify the debt

Before contacting creditors, it’s essential to know exactly how much debt you owe and who your creditors are.

Your credit report might not list all your debts. For instance, as of April 2023, medical debts with an initial balance under $500 are no longer included in U.S. credit reports. Additionally, older debts that are past the seven to ten-year reporting period might still be sent to collections.

If you have trouble tracking down older debts, try contacting the creditor directly or looking through old bills. Remember that most states have a statute of limitations that dictates how long a debt collector can pursue overdue debt.

Compile a list of your creditors and the current amounts owed to each.

2. Decide how much you can pay

Take stock of your available funds. Add up the balances in your checking accounts, savings accounts, and any other accessible cash.

Then, consider these questions: How much can you offer without depleting your emergency fund? Review your budget to determine how much you can realistically save each month for a settlement.

Use these figures to create a proposal for each creditor. It’s usually best to start with a lower offer than what you’re willing to pay, allowing room for negotiation.

If your creditor doesn’t accept your settlement offer, inquire about a payment plan. Think about payment plans that would work for you in case the creditor proposes a different arrangement.

3. Contact the creditor

Now comes the most challenging part of debt settlement: contacting your creditors with a settlement offer.

Creditors are more likely to consider your offer if you’re behind on payments. They might worry you’ll stop making payments entirely, so they may prefer collecting a portion of the debt over none at all.

During negotiations, ask your creditor to report the debt to the three credit bureaus (Equifax, Experian, and TransUnion) as “paid in full” rather than “settled” or “paid as agreed.” This can help improve your credit score more quickly.

Be prepared for some back and forth once you present your offer. Several phone calls or emails may be necessary before negotiations are complete.

4. Complete the deal in writing

Once you’ve reached a debt settlement agreement, send a letter to your creditor outlining the terms. Include the settlement amount and state that the creditor is accepting this amount as full payment of the debt.

Ensure you receive written confirmation from the creditor before making your payment.

5. Make your payment

Make your payment by the agreed-upon date. Send the funds to your creditor well before the due date to avoid any issues.

If you’re working with a debt settlement agency, you’ll likely make monthly payments until the agency collects enough to make the lump-sum payment on your behalf. In this case, you may stop making payments to your creditors. If you negotiate on your own, you might be able to continue making minimum payments to avoid late fees and interest charges.

Do not provide your bank account information. It is illegal for debt collectors to deduct money from your bank account without your permission. However, giving access to your account information can lead to unscrupulous collectors taking more than agreed.

6. Follow up with the credit bureaus

Regardless of the terms of your agreement, check your credit report after making your payment to ensure your creditor reported it accurately. You can obtain a free copy of your credit reports from AnnualCreditReport.com.

If you spot any errors, reach out to the credit bureaus to request a correction, or consider using a credit repair company for assistance.

Alternatives to debt settlement

If debt settlement feels too drastic, consider these alternatives:

  • Debt Consolidation: If you’ve been making timely minimum payments and your credit score is good to excellent, explore debt consolidation. You can use a personal loan, a home equity loan, or a credit card with a 0% introductory APR on balance transfers to pay off your debts and replace them with a single, more manageable loan.
  • Debt Management Plans: A credit counselor can help create a debt management plan, where they assess what you can afford and negotiate with creditors for lower monthly payments, reduced interest rates, or waived fees. You’ll make monthly payments to the counseling agency, which will then distribute the funds to your creditors according to the agreement.

If these options aren’t sufficient to regain control of your debt, more serious measures like bankruptcy may be necessary, as a last resort, to potentially discharge debts.

In Conclusion

Debt settlement can be a viable alternative to bankruptcy for many individuals. If you’re confident in your negotiation skills and have a clear strategy, you can approach creditors directly to propose settlements. If not, consider working with a reputable debt settlement company, which can save you time, stress, and potentially money. Be sure to research any debt relief company thoroughly to ensure it’s legitimate and has positive customer reviews.

While debt settlement can offer essential relief from financial burdens, it may negatively impact your credit score and lead to unexpected tax obligations. Weigh these potential consequences against the savings you might achieve, and proceed carefully.