September 28, 2020
By Rahul Iyer
A debt settlement is when you agree to pay your creditor or debt collector a large one-time payment towards your existing balance and in return, the remainder of your debt is forgiven. For example, let's say that you owe $7000 on a credit card, but you haven't made any payments for several months. Your creditor will have reported your missed payments and these will now be on your credit report and harm your credit score.
Generally speaking, credit card companies want all of their money back, but they also recognize that this isn't always feasible. If you go bankrupt, then they won't get any money back. To avoid this, the creditor might agree to forgive your debt if you pay a large portion of it upfront. So in this scenario, they might ask for a payment of $4000, and forgive the remaining $3000. In some cases, you can cut your balance by 50% to 70%.
There are two types of debt settlements, DIY settlements, and professional debt settlements. A DIY debt settlement is when you negotiate a settlement with the creditor directly, without involving a third party. This option is generally considered to be less expensive to the consumer, but it still comes with credit score damage you get with a professional debt settlement. A professional debt settlement is when you work with a third party and make payments to them. They will then negotiate with your creditors on your behalf.
No, most financial experts warn against using debt settlement programs, DIY or professional. Most experts recommend that you don't use a professional debt settlement service under any circumstances. There are also lots of scams out there so you have to be extremely cautious if you do want to proceed with debt settlement.
Although in principle they sound great, debt settlements are fraught with problems and often leave you worse off financially. Here are some of the reasons they are a bad idea.
It's Often Costly
Debt settlement firms charge fees for their service, but these fees will vary depending on your state's laws. Typically, you can expect to pay 15 to 25 percent of your enrolled debt as a fee. If we look back to our $7000 debt scenario, then it would work something like this:
You agree to settle the $7000 debt for $4000.
The firm you're working with charges a 25% fee. This is 25% of $7000, not 25% of the $4000.
You, therefore, pay a $1,750 fee in addition to your $4000 one-time payment.
Forgiven Debt is Taxable
The IRS considers forgiven debt taxable if it is over $600. In this scenario, the forgiven $3000 would be considered taxable income.
It Takes a Long Time
Debt settlement is not a quick process and often takes three to four years. This is largely due to how long it takes to negotiate with creditors. Often the firm will try to settle multiple debts from multiple creditors on your behalf, which is complicated and often unsuccessful. Studies have shown that fewer than 10% of consumers can settle all of their debts using a debt settlement firm.
And last but not least, your credit score can take a serious hit. To go through the debt settlement process, you have to stop paying your debts or speaking to your creditor and let the settlement firm take the reins.