Ultimate Debt Settlement Guide

This is Chapter 4 of 5 in our Ultimate Guide to Debt Relief series.

If you’re overwhelmed with debt and want to be debt-free as soon as possible, debt settlement can be a good option. It allows you to become debt-free by negotiating with creditors to forgive part of your debt.

Debt settlement is not for everyone and carries some risks. It’s important to keep this in mind as you consider debt settlement. Here’s what you need to know:

What is debt settlement?

Debt settlement is the process of negotiating with creditors to settle for less than you owe. You can work with a debt settlement company that will work with creditors on your behalf or you can negotiate on your own.

Settlement is typically used for unsecured debt, which is debt without collateral. Credit card debt is an example of unsecured debt. Secured debt has collateral that the creditor can use to recoup their loss if you fail to pay. Examples of secured debt include auto loans and mortgages.

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How does debt settlement work?

If you work with a debt settlement company, you’ll typically stop paying your creditors to help incentivize a settlement agreement. Instead, you’ll set aside money into a separate account that you control to be used to pay settlements once agreements are made.

Once settlements are reached and paid, you’ll owe the debt settlement company for its services. Costs are determined by state law and range between 15 and 25 percent of your total enrolled debt.

If you negotiate on your own, you’ll need to determine who each of your creditors are and what kinds of offers you’re going to make to each one. If you’re going to negotiate lump-sum payments, have some cash ready to make those payments.

Keep in mind that the IRS considers forgiven debt taxable income. You may owe more taxes due to a successful settlement than usual. Be prepared to set more money aside in withholdings so that you aren’t surprised with tax debt when you file your return.

As you consider debt settlement, you should be aware of the risks.

“The biggest risk is that you withhold payment for months and then one or more creditors sues you. Then you have the costs of the settlement, the taxes you'll owe on settled amounts, the fees, if any, that you pay to a settlement company, court costs and a judgment to your creditor. That's the worst case scenario,” says Gina Pogol, MoneyRates personal loans managing editor.

However, you still have options if a creditor starts seeking legal action, whether or not you’re enrolled in a settlement program.

“If one or more creditors threaten legal action, you should contact them and try to negotiate a compromise. If you are truly overwhelmed with debt, consider bankruptcy. That does stop lawsuits and does protect you. Even the threat of bankruptcy can motivate creditors to negotiate with you. Because in a bankruptcy filing, the court distributes payments and the creditors may get much less than if they work things out with you,” advises Pogol.

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What percentage of debt is usually accepted in a settlement?

It’s hard to say what a creditor will accept in a settlement. A lot depends on the creditor’s own financial situation, how much you owe, and the negotiator’s skills. Some debt settlement companies boast of the ability to negotiate your debt to as much as half of what you owe.

However, these statements should not be taken as a guarantee because the creditor ultimately makes the decision on whether or not they’ll settle with you.

If you’re negotiating lump-sum settlements on your own, it’s best to have between 20 and 50 percent of what you owe in cash that you can make a payment with.

Whether you hire a company or negotiate yourself, you should have realistic expectations about how much you can save on your debt.

“​The important thing is to understand that creditors don't settle unless they believe it's in their best interest to do so. And the 'pennies on the dollar' claim that settlement companies advertise has some caveats.

You can settle a very old collection account that was purchased by a debt collector for much less than you can a recent default to a primary creditor. That is because the debt collector with an old collection probably paid pennies on the dollar for the right to collect your debt. On average, these guys buy old debt for about 4 cents on the dollar. So they can make a profit if you offer 10 cents. You can settle a $2,000 debt for $200 in that way. However, it might not be a great idea.

Collections drop off your credit report after seven years. But settling that old debt makes it new and can harm your credit score. A recent default to a primary creditor, for instance, your VISA card, might be settled for 25 percent to 50 percent of the balance,” says Pogol.

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How does debt settlement affect your credit?

Debt settlement typically has a negative effect on your credit score and typically shows up on your credit report for seven years.

In most cases, you won’t make any more payments on any of your current debts. This will negatively impact your credit score. Luckily, if you change your financial habits, you can raise your score over time.

“As long as you keep up with your other obligations, whether it is a mortgage or auto loan, your credit score can rebound within one to two years. To accelerate this rebuilding process, you should try to open up a low limit credit card, or even a secured credit card, which will be easier to obtain. Paying these balances in full each month will slowly but surely increase your credit score and help you return to good standing with your credit,” suggests James Lambridis, DebtMD founder and CEO.

Once you’re debt-free, budget carefully and save to avoid debt. As you successfully manage your finances, you’ll be able to start increasing your credit score.

Each of the debts that you settle are marked as “settled” on your credit report. These markers stay on your credit report. However, the more time you place between your settled debts with good financial habits and keeping your debt low, the less it will matter.

There are also steps you can take to reduce the negative effect on your credit report.

“Debt settlement's effect on your credit depends on how you settle and how you negotiate the terms. If you make your payments on time and then offer a lump sum, AND get the creditor to report the account 'paid as agreed,' you have no repercussions. But, that would be a rare occurrence,” says Pogol.

If you’re negotiating with a collections agency, you can negotiate a pay-for-delete.

“A pay-for-delete means they remove the collection from your credit report in exchange for your payment. More typically, consumers miss payments for months, then settle and it's reported as ‘settled for less than the amount owed,’ which does real damage,” adds Pogol.

Keep in mind that even if you can negotiate some things on your credit report, you can’t remove any public record of legal action.

Pogol continues, “If any of the creditors take you to court, you have a public record in addition to the collection and missed payments.”  

Once you finish settlement, you should carefully review your credit report.

“One step in improving credit is to continue to check all your credit reports to make sure everything is reported correctly. This will help you to catch errors that need to be disputed. It also helps you to discover information that is not included in the reports that should be,” advises JeFreda R. Brown, Provision Financial Education CEO, Certified Financial Education Instructor, and Adjunct Finance Professor.

Rebuilding your credit after completing settlement can take some time. The most important part of rebuilding and moving forward is to develop strong financial habits and be consistent.

“An important part of improving credit is to also seek education. Getting personal financial education is vital. You need to be able to understand how your emotions, desires, and value affects your financial behavior. Financial psychology is a part of personal financial education that helps people learn these things and how to start changing negative financial behavior,” suggests Brown.

Understanding how you got into your financial situation will help you make different choices in the future. Maybe you’ll prioritize savings as you budget or limit your credit card use to certain kinds of purchases.

“Pay your bills on time, begin a savings fund, and begin to regularly monitor your credit report. Awareness is the first step towards improving the overall picture,” recommends Mike Weaver of Money Ladder.

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Should I work with a company or negotiate for myself?

If debt settlement is the approach you want to take, you’ll have to decide between negotiating yourself or hiring a company to do it for you.

Negotiating on your own

The largest advantage of negotiating on your own is that you are fully in charge. You don’t have to rely on recaps from someone else. You also won’t have to spend money on negotiation fees, which can add to your total “get-out-of-debt” costs.

If you negotiate yourself, you may be able to explore other items that can be negotiated in addition to lump sum payments. Settlement companies may not explore these other options on your behalf.

These additional options include interest, minimum payments, creating a hardship plan or workout agreement, and debt management. You may also be successful in negotiating how your settled debt will show up on your credit report.

The biggest drawback of negotiating yourself is the time commitment and the emotional work it can take. Negotiating for yourself can be an empowering experience. However, negotiations can take time and not always seem like they are getting somewhere. This aspect of the negotiation process can take an emotional toll because of heightened stress about your finances and working out a deal.

Another drawback is that your success negotiating on your own depends largely on your own negotiation skills. If you have great negotiation skills, that’s great. If not, you may not get as good settlements as you might by working with an experienced negotiator.

Tips for negotiating on your own

“If someone is negotiating their own debts, they definitely need to learn some key terms (definitions) so they understand credit and debt better. They also need to be able to have a knowledgeable conversation with their creditors to show the creditors that they cannot be taken advantage of. This will also show creditors that you are serious about paying your debt,” says Brown.

  • Gather information. Know the full amount you owe on each account. Create a monthly budget and understand what your regular income looks like. This information is important to share with any one you work with who’s giving you advice on your debt strategy.
  • Be familiar with financial lingo. If possible, it’s worthwhile to consult with an attorney. An attorney may be able to give you insight on how debt laws apply to your situation, which can inform your strategy going forward.
  • Know your creditor. If your initial creditor has sold your debts to a collections agency or another creditor, you need to know so that you start negotiating with the right person.

Once you know who you’re working with, you also need to research each creditor’s policies regarding settlement agreements. This knowledge will help you create acceptable offers.

  • Have a plan. Before you contact your creditor to start negotiations, you need to have an offer ready. Your initial offer should be based on what the creditor will accept, your current situation, and should be the most ideal situation for you.

“The most important thing for a person to know when negotiating debts involves knowing your terms. If you have an expert’s advice before going into the negotiation, and you don’t allow yourself to be pressured or swayed regarding what you can and can’t do, you’ll be in much better shape,” says Weaver.

Being certain of what terms you can accept and knowing your other options if a settlement is not accepted will help you be more successful. Before you make your initial offer, be sure that you have the funds on hand to pay it if it is accepted.

“You'd first need to come up with a sum of money to offer the creditors — say 25 percent of what you owe. Then, you'd send them all a letter offering that 25 percent as payment in full. Or, you'd offer an upfront sum plus a series of payments totaling some percentage of the balance owed. You would not send them anything without confirmation in writing that they will accept this,” says Pogol.

It can be helpful to have a counteroffer ready in case the creditor doesn’t accept your first offer. Before you make a counteroffer, you need to understand why the creditor rejected your first offer. This can help you decide how to approach your counteroffer or next step.

  • Explain your situation. While creditors probably don’t want to hear a bunch of excuses for not being able to make payments, it’s important to let them know if there’s anything uniquely challenging about your situation.

“You should always be sincere and truthful to the credit card companies. If you have a serious financial hardship, whether it’s a job loss or unexpected injury requiring you to take on medical bills, be sure to convey this to your creditors. They are more likely to work with people who are experiencing a hardship. In the end, they would rather recoup some money rather than nothing,” says Lambridis.

Before you talk to creditors, practice brief statements that clearly explain your situation and why you need some concessions from them. Be honest and don’t overstate your reasons for being behind on payments.

  • Ask questions. As you work with creditors, keep asking questions. The more questions you ask, the more information you’ll have about how the creditor handles settlement negotiations and what other concerns they might have.

Brown recommends a few topics to ask questions about:

“If someone is negotiating their own settlements, they need to understand how the creditors will report the settlements on the person’s credit report. The way that the debt settlement is reported has a major effect on the credit score. It would have a negative effect on a person’s credit score if a creditor reports the debt settlement like a bankruptcy.

Additionally, find out from the creditors what the effects of the settlement will be on your credit score. Stop using credit, and do not apply for more credit while negotiating settlements and while in the program.

Find out from the creditor how long it will take them to report that the debt is being paid and has been paid. It should typically be reflected within 30 days.”

  • Take notes and save your mail. Document your interactions, especially if they are verbal. Taking notes will help you remember how things stand with each creditor, which is important when negotiating multiple accounts. Review and keep any communication you receive about your accounts from the creditor.

Get everything in writing. Before you make any payments, be sure to get the agreement in writing. Make sure that the agreement has everything you discussed with the creditor and that you understand the terms. If you have a question or something is missing, work with the creditor again to get those things corrected.

  • Stick to the terms. Carefully stick to the terms of the agreement. If you do not keep the terms, then the agreement is void. It’s unlikely that the creditor will renegotiate with you, and you’ll be back in the situation you negotiated out of.

Hiring a settlement company

The best part of hiring a company to negotiate settlements is that you’ll have an experienced negotiator working on your case. Having someone with negotiation experience on your side can help you get the best settlements possible. Furthermore, you won’t have to deal with the emotional work of negotiating for yourself.

Because you won’t be doing the negotiating yourself, you’ll want to pick a company that offers good client communication. Most companies offer an online portal that clients can use at any time to check the status and progress of their account, which is helpful and convenient.

However, you’ll have to pay the company for its services, which can be expensive depending on how much debt you enroll and how much the company charges. Depending on state laws, debt settlement companies charge 15 to 25 percent of the total debt enrolled in the program. Fees are only collected once settlements are reached, so there are no upfront costs. Stay away from settlement companies that do charge upfront fees.

Take advantage of a free consultation to learn more about a company’s settlement program, cost, and how to disenroll from the program if your situation changes.

Most settlement companies have minimum debt requirements. In order to qualify for their services, you’ll have to enroll at least that much debt. Most companies won’t accept total debt amounts under $7,500. Some companies have higher requirements.

Tips for choosing a good debt settlement company

“People should definitely find out beforehand what a debt settlement company’s procedures and policies are. Read the fine print. Don’t sign anything or agree to anything that you do not understand. Definitely do not enroll in a program if you have been pressured to do so by the company’s representative(s),” advises Brown.

As you’re vetting debt settlement companies, you need to ask questions to make sure you understand the program and feel comfortable trusting the company with your case. Below are questions you should ask as you evaluate settlement companies.

  • What is the company’s track record and experience? You’ll want to pick a company that has several years of experience and a good track record of successfully negotiating settlements.
  • What do customer reviews say? While the company’s website will tell you plenty of positive things about the company, it is usually biased. Visit third-party review sites to read customer reviews to get a full picture of how well the company serves its clients.
  • Does the company offer a free consultation? It’s standard for debt settlement companies to offer a free consultation to review potential clients’ cases. If you’re considering a company that does not offer free consultations or are asked to pay upfront fees, you should find another company. Upfront fees and no free consultations are red flags in debt settlement.
  • Will I have one point of contact for questions and updates on my account? This question will help you gauge the kind of communication that you can expect throughout the settlement process.
  • Will a single representative or a team handle my case? Asking this question will help you understand the company’s approach to customer service and negotiation. There are pros and cons to each scenario, and you just need to be comfortable with the process.
  • How does the savings account for monthly payments work? Keep in mind that the monthly payment goes into a bank account under your control to save up for paying settlements. Make sure you understand how to access information on your account. You also need to understand if and how the available funds in your account will be accessed and used on your behalf.
  • What happens if I want to withdraw from the program? You should be able to withdraw from the settlement program at any time.

“In their contracts, most reputable debt settlement companies have a 'notice of right to cancel' which you can simply sign and send to them to withdraw yourself from the agreement. You should be wary of companies who make it difficult to cancel, as these are the ones who may not have their clients’ best interests in mind,” advises Lambridis.

Program withdrawal policies and processes may vary by company, so be sure to understand how this process works before enrolling.

Asking the questions above will help you understand a company’s approach and determine whether or not it is a good fit.

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What is the best debt settlement company?

Because debt settlement has so many risks and the reward is more uncertain than with other methods, it’s important to choose your debt settlement company carefully.

The questions in the previous section will help you vet companies to find a good fit. Best Company also ranks debt settlement companies by weighting customer reviews and considering other industry factors like time in business. No company can pay for a ranking on our site.

For more information on how Best Company ranks debt relief companies, visit our “How We Rank” page.

To see which company gets the top recommendation, visit the debt relief homepage.

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