If you are struggling with your finances, maxed out on your credit cards, and can't afford to pay all your bills, you may want to consider reaching out to your lenders to see if you can settle all or a portion of your debt. Settling debt can relieve you of some of your obligations, but there are also downsides to consider, such as how it may affect your credit score. Here is what you need to know.
Key Takeaways
- Debt settlement is an agreement between a lender and a borrower in which the borrower repays a portion of a loan balance and the lender forgives the remainder.
- You may need a significant amount of cash to settle your debt.
- Consider starting the negotiation by offering to pay 25% or 30% of your outstanding balance in return for forgiveness on the rest.
- Debt settlement can negatively affect your credit score, which can make it more difficult for you to secure financing in the future.
- Debt relief companies can help you resolve debt, but be aware of the potential for scams.
How Debt Settlement Works
Debt settlement is an agreement between a lender and a borrower, typically for a large, one-time payment toward an existing balance. The remaining balance is normally forgiven. It is often used when a borrower cannot keep up with their unsecured debts. For instance, you might be able to cut your credit card balance by up to 50%. So if you owe $20,000 on a credit card, you may be able to settle for half the balance if you can scrape up $10,000 in cash.
You can try to negotiate a debt settlement on your own, but it's typically done through third parties like debt relief companies, which you hire to negotiate on your behalf. With this method, you will make payments to the debt settlement company rather than your creditors, along with any fees.
Bear in mind that while there are legitimate debt settlement companies, there are also many scam operations. If you're considering one, the Consumer Financial Protection Bureau (CFPB) suggests contacting your state attorney general's office and local consumer protection agency to ask if they have any consumer complaints on file about that company. According to the CFPB, some states require that debt settlement companies be licensed, which may provide some added protection.
Once you've finalized your debt settlement with your lender, get the agreement in writing. If a credit card company only verbally agrees to a debt settlement, it can still legally turn over the remaining balance to a collection agency, which can have a larger impact on your credit score than a settlement.
Lenders are not legally obligated to lower your outstanding debt or offer a discounted payoff (DPO). But because they want to protect their bottom line, they may agree to a debt settlement to avoid taking an even greater loss.
Risks of Debt Settlement
Although a debt settlement can take some of the pressure off you, there are risks and downsides to consider.
First, a debt settlement will affect your credit score. This will make it more difficult for you to get credit or good interest rates in the future. A debt settlement typically remains on your credit report for seven years and you cannot remove it before then. On the plus side, settling a debt has less impact on your score than failing to pay completely.
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Another drawback for many people is that debt settlement requires you to have a substantial amount of cash available. If you don't have that money, you will need to consider how you will get the funds. Debt settlement companies often have you make regular payments to them toward an escrow-like account to be used for the payment to the creditor.
Another potential drawback is that when you settle debt, you could face tax consequences. For example, if you settle a $20,000 debt for $10,000, you will in most situations have to pay income taxes on the remaining $10,000 that was forgiven.
Finally, when you settle a debt with a credit card company, you risk having that account closed once the settlement is complete. So you could potentially have no credit line and no ability to use a credit card to make purchases.
Debt Negotiation Tips
If you're negotiating on your own, you'll want to explain your financial situation to your lender, and the sooner, the better. If your lender understands that you cannot pay your bills, and why, it will be more likely to work with you on a solution.
You should also avoid spending with a credit card that has a balance you want to settle. For example, lenders are less likely to settle if your credit card statement includes several charges for luxury goods. To improve your chance of success negotiating with a credit card company, try to avoid using that card for three to six months before you request a settlement.
Steps for Debt Settlement
Now that you have the basics of debt settlement down, it's a good idea to review some of the main steps involved with the process. Of course, each situation will be different, but these points serve as a guide on how to proceed when you're thinking of settling your debts.
- Review your situation. Make sure you write down everything you owe, including creditors, types of debt, and the total amount owing.
- Go through your monthly budget and see how much you can afford to pay when it comes to settling your debt. Be sure to account for your monthly income and deduct your expenses, such as rent/mortgage, bills, food, entertainment, and savings. This will help you establish whether you can make a large lump-sum payment and how much.
- Contact your creditor(s). Be sure to have hard numbers ready. And, as mentioned above, it's always a good idea to try to start low before you agree to an amount. In some cases, your creditor may not settle the account but may allow you to make large lump-sum payments over time. Although it may not be the desired outcome, it may be worth it so be sure to weigh out any options.
- If and when you do reach an agreement, ensure that your creditor puts it in writing. Read through the document(s) carefully and make sure you understand the terms and conditions of the deal.
- After reviewing the deal in writing, speak to the creditor. If you have any questions or concerns, be sure to address them. Once everything is clear, make your payment on or before the agreed-upon date.
- You'll want to make sure that your creditor reports the account settled with the credit bureaus. So be sure to follow up by reviewing your history to show that you met your obligation as agreed.
What Percentage Should You Offer to Settle Debt?
Consider starting debt settlement negotiations by offering to pay a lump sum of 25% or 30% of your outstanding balance in exchange for debt forgiveness. However, expect the creditor to counter with a request for a greater amount.
Do Settlements Hurt Your Credit Score?
Debt settlement can give you some short-term financial relief, but it can also hurt your credit score and make it more difficult to obtain financing in the future. Debt settlement companies will ask you to discontinue payment to your creditors while they negotiate on your behalf. Payment history is the most important component of your credit score; by missing any debt payments, your credit score will drop. And with a lower credit score, you may find that you only qualify for loans with high interest rates, if you can qualify at all.
How Do You Remove Debt Settlement From Your Credit Report?
When you settle an account with a lender, it will remain on your credit report for about seven years and will negatively affect your credit score. You cannot remove debt settlement from your credit report before then.
The Bottom Line
You can potentially lower your credit card debt by negotiating with a lender either on your own or with a debt settlement company, but keep in mind that a creditor is not legally obligated to accept less than what you owe.
If you cannot lower your total debt obligations through a settlement, you can try other strategies to help reduce the burden. For example, you may want to ask your credit card company if it can lower your card's annual percentage rate (APR) or provide an alternative payment plan that works for you. You can also consider debt consolidation through a debt consolidation loan that results in lower monthly payments.
For more guidance on the best options for your specific situation, consider consulting a professional financial advisor or a nonprofit credit counseling agency.
