Getting Out of Debt:
The Pros & Cons of Debt Settlement
If you are swimming in debt, you’re bound to start looking for a way out. Many people see debt settlement –an option that advertises to help you pay off your debt for much less than what you owe– as a way out of their financial woes. However, the truth isn’t quite as simple as all that. Debt settlement isn’t without pitfalls and consequences — and it isn’t for everyone.
What is Debt Settlement?
Debt settlement is, simply put, hiring a debt settlement company to help negotiate lower payoffs on personal loans, collections, and open accounts like credit cards. Sometimes these companies misleadingly advertise their services as a way to consolidate debt — or “debt consolidation,” — but make no bones about it, this is not a debt consolidation loan. Their main objective is to negotiate a settlement with all of your creditors and lenders.
Pros of Debt Settlement
There’s one obvious pro to debt settlement: a much lower, single monthly payment that you can afford. And, if a settlement is negotiated and accepted, you will pay much much less than you initially owed on the account. Many times this amount is less than 50% of the original debt, which can end up saving you quite a lot of money in the long run.
Cons of Debt Settlement
Now for the cons, there are quite a few so stay with me. Debt settlement should only be used by those that already have very poor credit. If not, your credit standing and your credit score will be severely damaged for quite a while.
What the debt settlement companies fail to tell you is that when you settle a debt, the lender, collector, or credit card company will report the debt as “settled for less than agreed” or “settlement accepted,” damaging your credit report cards for seven years. Plus, even though you’re ignoring your lenders (as directed by the settlement company), they will continue to report late payment status updates to the credit bureaus, which will continually get worse until the account is charged off or goes to collection — or is settled, which is the settlement firms main goal.
Another drawback is that while you’re paying the settlement company, most won’t tell you exactly how much of your monthly payment is going towards your debts and how much is actually being deducted as their “fee.” Oh yea! Forgot to tell you this, if the collector except your settlement offer then the remaining amount is considered a charge off and is reported to the IRS as income not taxed. The IRS will tax you on this amount, which could cause a family crisis.
The Alternative: Debt Management Program
Debt settlement isn’t the only option for people who are swimming in debt. If you’ve tried debt management on your own and are still struggling and need help, you may want to consider a Debt Management Program (DMP). DMPs are often run on a non-profit basis through a consumer credit counseling service, and have no motivation other than wanting to see ordinary people get out of debt. The fees are minimal, and much lower than you’ll pay a settlement or consolidation company — and you’ll pay off your debts, typically in less than five years, without all the damage to your credit and credit scores.
Another great thing about legitimate credit counseling services that offer DMPs is that they can also help you evaluate your debt situation, and if you’re not a good candidate for a DMP, they can help you determine if bankruptcy is an option — always a last resort, but there are cases where it’s the only option left.
Before you decide on a credit counseling service, make sure they are legit. You can do this by verifying that they are a member of the National Foundation for Credit Counseling by visiting their website or by calling 1.800.251.CCCS.
Best Ways to Get Out of Debt
Using a HELOC
A HELOC, or a home equity line of credit, is a revolving line of credit secured by equity in your home. That line of credit can be tapped and used for whatever you like; to pay off debt, to buy a car, to pay college tuition, or just to have as an emergency fund. HELOCs are commonly used to pay off credit card debt because the interest is tax deductible and the interest rates are relatively low.
The danger when using a HELOC is what happens if you go into default. Because a HELOC is secured by the equity in your home the bank can foreclose on your house if you don’t pay back the loan. For some people that’s far too much of a gamble just to pay off a little credit card debt.
Using a Balance Transfer
If you’ve got good credit then you’re probably already getting offers for zero percent credit cards. These are tempting, and for good reason. Converting your expensive credit card debt to zero interest credit card debt is a considerable trade off in your favor.
Many of these credit cards allow you to transfer your entire interest accruing balances from other cards AND allow you to make new purchases, all at zero percent interest for some period of time. If you’re disciplined you can use the grace period, normally between 6-12 months, to aggressively attack the balance and get out of the debt.
Using a Personal Loan
A personal loan is an unsecured installment loan. If you’ve got good credit it’s not that hard to qualify for personal loans well above $10,000. If you use the funds from a personal loan to pay off credit card debt then your credit scores should shoot through the roof because you’ll be converting score damaging revolving debt into score benign installment debt.
As far as the cost of the installment loan, it’s possible the interest rate will be considerably lower. If you have good credit you can get an installment loan in the low teens, while your credit card debt might be as expensive as the high 20s. Plus installment loans have a much shorter payoff period compared to credit cards.
Debt settlement: Will it work for me?
In a Nutshell
Debt settlement is a practice that allows you to pay a lump sum that’s typically less than the amount you owe to resolve, or “settle,” your debt. It’s a service that’s typically offered by third-party companies that claim to reduce your debt by negotiating a settlement with your creditor. Paying off a debt for less than you owe may sound great at first, but debt settlement can be risky, potentially impacting your credit scores or even costing you more money.
Debt settlement is a service offered by third-party companies that try to reduce your debt by negotiating settlements with your creditors or debt collectors. But there are risks involved.
Although it may be tempting to use a debt settlement service to reduce your debt, it’s important to keep in mind that you could end up deeper in debt or with a negative impact to your credit.
Here’s some key information you should know about how debt settlement works, its pros and cons, and how it could affect your credit.
How debt settlement works
Debt settlement companies may also be known as “debt relief” or “debt adjusting” companies. The companies generally offer to contact your creditors on your behalf, so they can negotiate a better payment plan or settle or reduce your debt. They typically charge a fee, often a percentage of the amount you’d save on the settled debt.
Learn more about different types of debt relief and how they work.
The company may try to negotiate with your creditor for a lump-sum payment that’s less than the amount that you owe. While they’re negotiating, they may require you to make regular deposits into an account that’s under your control but is administered by an independent third-party. You use this account to save money toward that lump payment.
While they negotiate, the debt settlement company may also advise you to stop paying your creditors until a debt settlement agreement is reached.
Once the debt settlement company and your creditors reach an agreement — at a minimum, changing the terms of at least one of your debts — you must agree to the agreement and make at least one payment to the creditor or debt collector for the settled amount. And then the debt settlement company can begin charging you fees for its services.
Keep in mind that there is no guarantee the company will be able to reach a debt settlement agreement for all of your debts. Remember there are some debts that do not qualify for debt settlement, so remember to factor in all remaining payments along with the settlement payment.
SOME DEBTS THAT DO NOT QUALIFY
Car, Truck, Van or Motorcycle loans
Federal student loans
Mortgages (secured with Collateral)
Child Support, just to name a few
How to ask for help when you’re struggling financially.
Debt settlement: Benefits and risks
There can be a few pros to debt settlement, but you should carefully consider the potential risks of debt settlement as well.
Settling a debt through a debt settlement company could …
Lower your debt amount
Help you avoid bankruptcy
Get creditors and collectors off your back
But the risks may outweigh the benefits.
1. Your creditors may not agree to negotiate
Not only is there no guarantee that the debt settlement company will be able to successfully reach a settlement for all your debts, some creditors won’t negotiate with debt settlement companies at all.
2. You could end up with more debt
If you stop making payments on a debt, you can end up paying late fees or interest. You could even face collection efforts or a lawsuit filed by a creditor or debt collector. Also, if the company negotiates a successful debt settlement, the portion of your debt that’s forgiven could be considered taxable income on your federal income taxes — which means you may have to pay taxes on it when you file your IRS 1040 at the end of the year..
3. You may be charged fees, even if your whole debt isn’t settled
Debt settlement companies can’t collect a fee until they’ve reached a settlement agreement, you’ve agreed to the settlement, and you’ve made at least one payment to the creditor or debt collector as a result of the agreement. But you could still end up paying a portion of the debt settlement company’s full fees on the rest of your unsettled debts, says Bruce McClary, senior vice president of communications at the National Federation for Credit Counseling.
“If you have five or six creditors and the company settles one of those debts, they can start charging a fee as soon as they receive a result,” McClary says.
And if a debt relief company settled a “proportion” of your total debt enrolled with its program, it can charge you that same proportion of its total fee. For example, if your total debts came to $10,000, and a debt relief company settled $5,000 of the total amount, it’s allowed to charge 50% of the total agreed-upon fee.
4. It could negatively impact your credit
A debt settlement company may encourage you to stop making payments on your debts while you save up money for a lump-sum payment. But at this point, your creditors might not have agreed to anything, which means all those payments you’re missing can wind up as delinquent accounts on your credit reports. Your credit scores could take a hit as a result of any delinquent payments, and the creditor could also send your account to collections or sue you over the debt. Debt happens for many reasons.
Alternatives to debt settlement
1. Negotiate your own settlement
Try negotiating settlements with credit card companies or other creditors on your own. Offer an amount that you can pay immediately, even if it’s less than what you owe.
2. Transfer balances
If you have credit card debt, consider a balance transfer. A balance transfer is when you move debt from one credit card to another, usually to take advantage of an introductory 0% interest offer on the new card.
Balance transfer cards typically have one of these 0% intro APR offers for a specified period of time and may charge a fixed fee or a percentage of the amount you transfer.
To figure out if a balance transfer is a good idea for you, check whether you’ll pay more money on the interest payments on your current card than the cost of any balance transfer fees. And you should also try to pay the balance off before the card’s promotional period expires to avoid paying interest on your balance.
3. Seek nonprofit credit counseling
Nonprofit organizations may provide credit counseling services that offer free or low-cost advice on budgeting and debt management. Credit counseling agencies don’t typically negotiate to reduce debt. But a credit counselor may work with creditors on payment plans or to stop late fees or efforts like collection calls.
Next steps if you want to go ahead with debt settlement
Do your research. The Federal Trade Commission helps protect consumers by trying to prevent unfair business practices in the marketplace. The FTC has useful information on debt settlement that’s worth reading as you consider debt settlement options.
Pick a reputable debt settlement service provider. Before you enroll in any debt settlement program, the Consumer Financial Protection Bureau recommends contacting your state attorney general and local consumer protection agency to check whether there are any complaints on file. The state Attorney general’s office can also check if the company is required to be licensed and whether it meets your state’s requirements.