What Are the Risks of Debt Settlement?

Guest Post by Orlando Rodríguez 

DISCLAIMER: The information provided in this article does not, and is not intended to be, legal, financial or credit advice; instead, it is for general informational purposes only. 

Debt settlement is when creditors or collection companies agree to clear a debt for less than you owe. It sounds simple in principle — and very convenient — but is it a money-saving tactic or a credit trap? What are the risks of debt settlement, and what are the alternatives?

If you’re confused by debt settlement, you’re in the right place. In this brief guide, we’ll explore what the term means, and how it can affect your credit.

What is debt settlement?

When you settle a debt, you pay your creditor or a collection agency less than you owe, including existing interest and fees. Debt settlements are usually lump-sum payments, though some organizations allow consumers to set up payment plans instead.

Debt settlement pros include:

• Reduced pressure from creditors
• A fresh financial start
• The chance to avoid bankruptcy

The risks of debt settlement include:

• Serious credit damage
• Unexpected tax bills
• Extra fees and penalties

Before you negotiate with a creditor or collection agency, think seriously about your options. Don’t make any decisions until you know what you’re up against.

What are the advantages of debt settlement?

We touched on the advantages of debt settlement briefly above. Now, let’s look at each plus point in a little more detail. 

Reduced financial pressure

Debt can feel like a crushing weight. Constant calls from creditors and collection agencies cause anxiety, and the guilt associated with outstanding debt can lead to mental health issues. Perhaps unsurprisingly, getting rid of a debt can bring emotional relief.

A fresh start

If you currently pay a lot of money toward your debts every month, opting for debt settlement could help you find financial balance in the long term. Debt settlement offers don’t appear by magic — it takes a while before creditors begin to negotiate — but they’re a quicker route to a debt-free status than minimum payments. After you eliminate your debts, you can start again. That’s perhaps the biggest debt settlement plus.

No bankruptcy

Debt settlement can help you avoid bankruptcy. If you have assets you’d rather not part with, or you’re worried about the impact personal insolvency might have on your small business, you could be better off settling your debts than filing for Chapter 7 bankruptcy. If you’re hovering between bankruptcy and debt settlement, consult with a financial professional to find the best option for you.

What are the negative effects of debt settlement?

It’s wonderful to imagine a fresh start—an end to overwhelming monthly payments and the shame associated with unmanageable debt. There are downsides to debt settlement, however.

Serious credit damage

When you settle a debt for less than you owe, it makes a negative impact on your credit report. When you negotiate settlement terms and your original contract with the lender is modified, you’ll damage your payment history and your credit score will go down. Unless you’re able to negotiate to have them removed, delinquent payments and collection accounts will stay on your report for seven years—even if you settle. The impact on your credit score depends on the terms of the settlement and how it’s reported on your account.

Unexpected tax implications

Many people are surprised by the tax implications of debt settlement. When you settle a debt for less than you owe, part of it is written off—and the IRS sometimes considers the forgiven portion taxable income. On the face of it, that doesn’t seem fair—after all, you didn’t physically receive the forgiven portion of your debt. Nevertheless, you may need to report that amount to the IRS and if applicable, pay taxes on it.

The tax-related rules that apply to debt forgiveness are pretty complex. To find out where you stand, ask an accountant or a financial advisor before settling debt.

Extra fees and penalties

Debt settlement strategies take time to come to fruition. While you wait for an opportunity to negotiate, your unpaid debts will accrue interest and fees. Sometimes, collection agencies charge additional recovery fees, which they apply when they agree to a settlement. If you agree to the settlement amount, if part of your agreement, you’ll also need to pay those fees.

What are some alternatives to debt settlement?

Not sure debt settlement is right for you? In that case, consider these alternatives:

• Renegotiation — Ask your creditors for an interest rate reduction, or talk to them about reducing monthly payments.
• Debt consolidation — Consolidating your credit cards and loans into one single lower monthly payment can greatly reduce the amount you spend on debt every month. 
• Credit counseling — If you have trouble creating a workable budget and need help figuring out your finances, speak to a credit counselor or financial advisor.
• A debt management plan — Under the terms of a DMP, you make payments to reduce the amount you owe to all your creditors at once.
• Chapter 13 bankruptcy —Your finances get reorganized and you make court-mandated payments for a set amount of time after you file for Chapter 13 bankruptcy. 
• Chapter 7 bankruptcy — Chapter 7 bankruptcy wipes the slate clean—but it’ll be difficult to obtain credit for a while, and the bankruptcy will stay on your record for 10 years.

Bankruptcy is arguably the most extreme solution to debt. Consumers who opt for Chapter 7 bankruptcies have to liquidate many of their assets before they’re deemed debt free. Under the terms of Chapter 13 bankruptcies, people are allowed to keep some of their assets. Chapter 13 is safer if you own your own home or have valuable possessions you want to pass on. Speak to an experienced financial advisor and consult with a bankruptcy lawyer before choosing voluntary insolvency.

How do you settle a debt?

If you decide to proceed with a debt settlement strategy, you can take a DIY approach or work with a debt settlement company. Let’s review both options. 

The DIY route

Creditors are unlikely to negotiate with you if they believe you can continue to make monthly payments or that you can pay the debt in full. To move into debt settlement territory, it’s best if your accounts are already delinquent by at least 90 days. If you want to continue missing payments while negotiating, know that there are serious credit-related ramifications associated with terminating payment in this way.  So, consider keeping up with payments while at the same time building a lump sum to pay off the debt. Before you quit paying, talk to your creditors about reducing monthly payments. 

If you do stop paying your loan or credit card bill, late charges and fees will accrue and your credit score will drop. So, if you go the DIY route, know what you can and can’t afford to do, and find an agreement with the creditor that works best for your situation. 

Note: Remember, your credit score will drop dramatically if you stop paying your debts, so you’ll find it very difficult to obtain a loan or a credit card—possibly for years.

A settlement company

If you have a lot of debts to settle and haven’t been able to negotiate with your creditors independently, a settlement company can help take the pressure off. Settlement companies negotiate with your creditors on your behalf, reducing the amount of direct contact you have with the companies you owe money to.

Settlement companies usually charge fees. So, it’s important to factor those into your payment estimates. On the flip side, they can help you recover a sense of financial stability and may also provide budgeting advice. 

Note: It’s hard to define what percentage of a debt is typically accepted in a settlement. Some companies won’t take less than 70 percent of what you owe, while others will go as low as 30 percent.

Is debt settlement really worth it?

In short, debt settlement is sometimes worth it if you can’t afford to pay off what you owe in full. If the risks of bankruptcy outweigh the benefits for you, and if you feel trapped under a mountain of debt, a settlement offer might bring peace of mind.

If you decide to settle one or more of your debts, seek advice from a qualified tax professional about tax implications. Draft a savings plan to ensure you have the money to pay any taxes you owe at the end of the year, and create a solid budget to keep your finances on the level in the future. Finally, check out credit repair options, some of which could help you rebuild a solid credit profile.

Orlando Rodríguez is a writer and content specialist for the Credit.com team dedicated to creating helpful, informative and eye-catching content. He completed his undergraduate work at the University of Utah focusing on Film and Media Arts. He’s written blogs and journalistic content for many different industries, and narrowed down his niche to the financial industry. In his off time, Orlando puts effort into crafting creative content around the arts.