What Is Debt Settlement?

What Is Debt Settlement? article image.

Debt settlement is a process of negotiating with lenders in hopes they'll accept less than what you owe them. Debt settlement companies manage this process with the understanding that you'll pay them if they succeed in getting your debts reduced or forgiven.

Typically pursued as a last-ditch alternative to bankruptcy, debt settlement is a risky process with no guarantee of success that can severely damage your credit.

How Does Debt Settlement Work?

With debt settlement, debt relief companies typically have you stop making all payments to your creditors and instead have you make monthly payments into a savings account they set up for you. They'll then try to use the money in that account, even if it's less than you owe, to pay off your debt. Depending on how many creditors you have and the size of your outstanding debt, collecting enough money to make a worthwhile offer to lenders could take as long as three or four years.

When the debt relief company determines it has sufficient funds, it reaches out to your creditors on your behalf, offering partial payment of your debts as a preferable alternative to getting no payment at all. The implication is that if you file for bankruptcy, lenders may not ultimately collect any of what they are owed.

If the negotiations succeed, the debt settlement company charges you a percentage (20% to 25% is common) of either the amount it saves you or of your total debt. Debt settlement accounts often charge additional fees as well (for setting up and maintaining your savings account, for example).

What Is the Difference Between Debt Management and Debt Settlement?

If you're in dire financial straits and considering debt settlement, it's probably a good idea to investigate the similarly named but significantly different option called debt management.

Like debt settlement companies, debt management programs (DMPs) can help you reorganize your finances, and the provider of a DMP can intervene with creditors on your behalf to help negotiate interest rate reductions, extended repayment time spans settlements. Unlike a debt settlement company, DMP providers have a goal of helping you pay your debt in full in a way that does minimal harm to your credit.

Another important distinction is that DMP providers are nonprofit companies, in contrast to for-profit debt settlement companies. That doesn't mean DMP services are free (although they may be if you meet certain income requirements), but it does mean DMP providers are less likely to charge high fees or to insist you use their services when other options are more viable.

Debt management programs can take a toll on your credit as successful DMP participation can result in creditors closing your accounts. Whenever you close an account, it's important to understand how it will affect your credit utilization ratio, which measures the percentage of your total credit limit you're using. Credit utilization is the second-most important factor in your credit scores, and closing accounts may cause it to jump—potentially dinging your credit scores. Still, following a DMP repayment plan will likely leave your credit in a much better place than would debt settlement.

Does Debt Settlement Affect Your Credit?

The single biggest factor in your credit scores is your payment history. If you're a candidate for debt settlement, you may have already missed or made late payments, but if your payment history is good going into the debt settlement process, it won't be for long. A debt settlement company's instructions to withhold payments from your creditors (and instead make payments into a savings account) will certainly bring a rapid, steep drop in credit score if you haven't missed any payments, and it'll likely drag down your scores even if you've had a spotty payment history.

In addition, willful nonpayment of creditors over a span of months or years will likely lead some creditors to charge off your debts and sell them to collection agencies—events that lead to significant negative credit report entries. These entries stay on your credit report for seven years from the date of the initial delinquency that caused them.

The combination of credit score damage and negative credit report entries can significantly limit lenders' willingness to issue you loans or credit.

Is Debt Settlement Worth It?

Bankruptcy has the most severe negative impact on personal credit of any single event, and debt settlement should only be considered as a last-ditch alternative to filing for bankruptcy—assuming all other options have been exhausted. Be aware, however, that for at least some individuals, debt settlement may not provide any meaningful benefit over bankruptcy.

Depending on how high your credit score was prior to pursuing debt settlement, and how many other negative events you have on your credit report when you begin the process, debt settlement can be just as damaging to your credit scores as a bankruptcy. Associated negative credit score entries (missed payments, charge-offs and accounts sold to collection) all stay on your credit report for seven years from the date of the first missed payments that caused them—the same amount of time that Chapter 13 bankruptcy stays on your credit report.

The credit score impacts of all these negative events begin to diminish before their seven-year expiration date, but since Chapter 13 entails structured repayments to creditors similar to a debt settlement payment plan, it could cost you less and leave your credit in better shape after seven years than debt settlement does.

Depending on your total amount of debt and the way a debt settlement company may structure its fees, expenses associated with debt settlement can exceed those associated with a bankruptcy filing. (This is especially true if you qualify for Chapter 7 bankruptcy,)

If your creditors refuse the terms offered by your debt settlement company, you may have little choice but to file for bankruptcy anyway—but only after racking up fee payments to the settlement company and losing months or years you otherwise could have spent rebuilding your credit.

Debt settlement companies are a viable option for some consumers seeking to avoid bankruptcy, but the risk and expense they bring mean may mean that debt management programs, and even bankruptcy itself, may be better options.