The Complete Guide to Debt Settlement

Debt relief companies, including settlement companies, can help reduce your balances and put your mind at ease. But, before working with a debt settlement service, I urge you to consider the fine print and risks that may have a longstanding impact on your credit. Here’s how debt settlement works and whether or not it's right for you.

What is debt settlement and how does it work?

Debt settlement, a form of debt relief, is when a creditor agrees to accept less than what you owe them to settle the account.

If you’re having trouble repaying debt, your creditor (or the debt collection agency that has taken over the debt) may be willing to accept a lesser amount of money to remove the debt from their books.

Depending on the agreement, you might pay the settlement in a lump-sum payment or through an installment payment plan.

You can either hire a debt settlement company to work on your behalf or handle the debt settlement yourself. Either way, here’s what happens:

• Set money aside: If you want a lump sum settlement, you’ll need adequate funds set aside for you or the debt settlement company to make the offer.
• Negotiate with creditors: Either you or your counselor will negotiate with creditors to come up with a settlement. This step could take some back and forth between parties, and takes some persistence on your part, since not all creditors will settle on the first try.
• Ask for a written agreement: Don’t rely on a verbal agreement as there’s no proof of what the creditor offered. Instead, ask for a written agreement so you have the proof should the creditor not honor what they promised.
• Follow the agreement: If your creditor accepts a settlement offer, you will start making payments to satisfy your end of the deal. Creditors often settle for 40%-80% of the amount owed, but it varies by creditor and can be more or less.

Let's look at an example using a 40% settlement amount. If the total debt on your credit card is $15,000, you could end up paying somewhere around $6,000. However, if you use a debt settlement company, you’ll also pay their fees.

Once you settle the debt, the creditor should remove the account balance from your credit report. The report should say that you settled with the credit card company for an agreed amount.

Keep in mind, though, that according to the Federal Trade Commission (FTC), debt settlement programs may require you to deposit your money into a savings account for 36 months or more until a settlement is reached. This can have a significant negative impact on your credit score, which is why handling the negotiations yourself may be a better option.

How debt settlement programs work

A debt settlement program is offered by a for-profit business called a debt settlement company or debt relief company. Essentially, these businesses work with your creditors to negotiate a deal allowing you to pay off (settle) your debt for less than the total amount. Notice, I said they charge a fee, so you pay money to save money.

However, if you owe multiple creditors and a debt settlement company negotiates a settlement with all of them, you will only need to make a single monthly payment to the company that negotiated on your behalf to fulfill the settlement terms.

Eliminating your debt is often a win-win scenario for all parties — you’re no longer on the hook for the full amount of your balance, and the debt collector also gets some money.

Best debt relief companies at-a-glance

I urge you to carefully research any debt relief companies you consider as this is an industry fraught with scams.

Two reputable companies are the National Debt Relief and Freedom Debt Relief companies. Each company offers slightly different debt relief solutions, but both offer free consultations and debt counselors to help you create a plan that works for you. They also work on a similar fee structure and have the same minimum debt balance requirements for using their services.

	Freedom Debt Relief	National Debt Relief
Minimum debt	$7,500	$7,500
Program length	24-48 months	24-48 months
Fees	15-25% of total enrolled debt	15-25% of total enrolled debt
Availability	Approximately 38 states	42 states
	Visit Freedom Debt Relief	Visit National Debt Relief

Should you settle your debt or pay it in full?

It’s always best to pay your debt in full, if you can. Even if you get a settlement agreement from the creditor, your account will show “settled for less than the full amount” or “settled as agreed.”

While this puts you right with your original creditors, it shows potential lenders that you paid less to your lenders than you originally agreed. This could have a negative impact on your credit score and ability to borrow in the future.

On the other hand, any debt account balances you completely pay off will be marked "paid in full" on your credit report. This signals to potential future lenders that you have a history of paying off every dollar you borrow and could help improve your credit score.

What types of debt are eligible for settlement?

You may not be able to settle every type of debt you have. It depends whether you have secured or unsecured debt.

Unsecured debt is the type of consumer debt eligible for debt settlement. Secured loans are already backed by property, such as your car or house. If you don’t make your payments on secured loans, the lender can repossess the collateral and sell it, leaving them with no incentive to negotiate with you.

Here are examples of debt you may be able to settle:

• Credit card debt
• Medical bills
• Unsecured personal loans
• Payday loans
• Private student loans

Pros and cons of debt settlement

Settling debts has its pros and cons. Here’s what to consider before deciding how to proceed.

How does debt settlement affect your credit?

Debt settlement can have a drastic impact on your credit score. Here’s what to expect:

Lower credit utilization

On the bright side, getting rid of high credit card account balances can reduce your credit utilization ratio, which could help your score. Your credit utilization ratio accounts for 30% of your FICO Score calculation.

However, a lower credit utilization may or may not undo the damage done by missing payments ahead of a settlement. That’s because payment history accounts for 35% of your FICO score calculation.

Missed payments hurt your credit score

The degree to which missed payments impact your score depends on your finances and history. According to data from the leading credit bureaus, missing payments do more harm to your score the higher your credit score.

For instance, someone with good credit (a FICO Score of 710) could lose as many as 180 points if a payment is 90 days late. Meanwhile, someone with a FICO Score of 607 might lose 47 points when a payment is 90 days late.

If your credit is already less-than-stellar, the benefits of settling debt could be worth the credit hit because you can work on rebuilding with a clean slate.

How to choose a debt settlement company

If you decide to go the settlement route, here’s how to pick the best debt settlement company for you:

• Compare fees: Shop around with multiple companies to compare prices and terms. Opt for a company that doesn't charge upfront fees.
• Look at the company’s track record: Check the Better Business Bureau to review company ratings and search the Consumer Financial Protection Bureau database for complaints. The FTC also recommends checking with your state attorney general’s office to see whether complaints have been filed against the company.
• Read customer reviews: See what people are saying about the company and its customer service, but remember to look at the big picture.
• Ask questions: Check each company's website or call and ask about their debt settlement process, including how long the debt negotiation process typically takes.

National Debt Relief vs. Freedom Debt Relief

Minimum debt	$7,500	$7,500
Types of debt	Credit card debt Payday loans Store credit cards Unsecured debt (including medical debt and personal loans) Private student loans	Credit card debt Payday loans Store credit cards Unsecured debt (including medical bills and personal loans) Private student loans
Program length	24-48 months	24-48 months
Fees	15%-25% of the amount of your total enrolled debt	15%-25% of the amount of your total enrolled debt
Availability	42 states	Approximately 38 states
Accreditation	AFCC, IAPDA	AFCC, IAPDA
Best for...	Clients looking for top-notch customer service	Clients with hefty debt balances looking for affordable debt relief
	Visit National Debt Relief	Visit Freedom Debt Relief

How to avoid debt settlement scams

Unfortunately, the debt relief industry is known for scams. Companies may try to exploit your financial hopelessness and fear, so don’t make rash decisions in desperation.

The scams often involve promises that settlement companies can't guarantee.

For example, they can't:

• Guarantee that your creditor will be open to negotiating or guarantee to erase a specific percentage of your balance
• State they can make your debt disappear or stop litigation if you don’t pay your debt

The FTC also warns against doing business with settlement companies that charge money upfront.

The debt settlement company should disclose the fees, how long the process will take, how much you need to save for the settlement, and the risks involved if you don’t make debt payments.

If a debt settlement company sounds too good to be true, it's a sign that it may be a scam. If you’re the victim of a debt settlement scam, you can file a complaint with your state attorney general’s office.

Alternatives to debt settlement

I encourage you to exhaust all other options before considering debt settlement. Here are some alternatives.

Negotiate yourself

Instead of paying a debt settlement company a fee for the service, you can try to negotiate with creditors on your own.

If you’re going through financial hardship for an unavoidable reason, creditors may be willing to establish a payment arrangement so you don’t default.

Creditors may prefer to speak with you and, in some cases, refuse to speak with settlement companies. Learning how to settle credit card debt yourself can often be as easy as picking up the phone.

Use a debt consolidation loan

If you’re juggling many payments to different creditors, you may be able to consolidate your debt with a debt consolidation loan. This will combine all your debt under one new loan for more manageable repayment.

Debt consolidation loans are often installment loans with a fixed interest rate and repayment term and you should compare debt settlement and debt consolidation before deciding.

Consider a balance transfer credit card

Some credit cards offer new cardholders a 0% APR balance transfer special where you pay no interest on transferred debt during an introductory term. If approved, you could have over a year of interest-free time to repay your debt.

For instance, the Citi Double Cash^® Card offers a 0% intro APR on balance transfers for 18 months (then 18.49% - 28.49% (Variable) APR).

Check out this list of the best balance transfer cards if you're interested in comparing cards.

Try credit counseling

A nonprofit credit counseling agency may help you with a debt management plan so you can tackle your outstanding balance.

A credit counselor provides guidance and support for consumer credit, including reviewing your finances and negotiating with creditors to secure lower interest rates and fees. You make one payment to the counseling agency, which disburses it to your creditors.

Enrolling in this kind of debt repayment plan won’t hurt your credit score, but credit counseling companies typically charge an upfront fee and monthly fees.

According to the National Foundation for Credit Counseling, the cost should be around $50 or less upfront and $25 per month. This could be much less than paying a debt settlement company and the IRS in taxes owed on the settled debt.

Speak with an attorney about bankruptcy

If you’re at a point where you don’t have enough cash to spare to save for a settlement and your debt payments are not manageable, you might consider the bankruptcy pros and cons.

A bankruptcy attorney can discuss options with you, including whether you qualify for Chapter 7 bankruptcy or Chapter 13 bankruptcy.

FAQs

Bottom line

Working with a debt settlement company could be an option to consider if you’ve exhausted other repayment solutions. I encourage you to look at all options to avoid debt settlement. If you decide it’s the only option, be sure you understand the risks of hiring a debt settlement company. If the settlement company can’t reach an agreement with your creditors, you could end up with a much higher unpaid debt balance and in court for the amount you owe.