A debt settlement is when a creditor agrees to accept less than what is owed on a principal balance of a debt.
Many agencies offer Debt Settlement Services, often charging high upfront or ongoing fees when individuals are already experiencing financial distress.
An individual can work directly with a creditor to settle a debt on their own but must have a lump some of money to offer the creditor(s) and be prepared for settlement negotiations.
For example; Molly is behind on her store charge card and owes $1500. Molly negotiates with the creditor to pay 65% of her total debt and the creditor agrees. Molly pays the lump sum settlement amount of $975.
What are the Incentives?
For creditors, the primary incentive is to recover funds that otherwise would have been lost if the account was charged-off to a collection agency or the debtor filed for bankruptcy relief.
For consumers, the primary incentives are to avoid paying debts in full or to avoid the stigma that is sometimes associated with bankruptcy.
What are the Consequences?
A debtor can still be sued during the debt negotiation process. Typically, during the time frame that the debtor is saving funds to make a settlement offer, the creditors are not receiving regular payments therefore the account is in default. During this period a creditor can pursue legal action that may result in wage garnishment or lien.
The debtor’s credit profile is also damaged during debt settlement. The payment history accounts for approximately 35% of the credit score while the amounts owed account for about 30% of the score. As the debtor makes payments to a trust account with a settlement agency or saves money to make a settlement offer on their own, it is typical that the credit accounts are not receiving any payment. At the first late payment, late fees are charged. Late fees make the account balance become larger. Late payments and higher balances are then reported to the credit reporting agencies affecting your score negatively.
Settlements may also result in higher taxable income. The Internal Revenue Service considers most of forgiven debt or cancelled debt as taxable income depending on the insolvency of the debtor at the time the debt was forgiven. The debtor will receive a 1099-C tax form from the creditor if $600 or more was forgiven. In addition, creditors may sell the remaining portion of the debt to a collection agency; either way, the debt does not disappear.
Creditor collection calls may sharply increase. Depending on the amounts of debt and the length of time to save enough money to settle them, creditors generally do not receive payment resulting in more aggressive collection efforts. Collection calls can be stressful to deal with day after day, month after month and is the number one reason people seek help to solve debt problems.
Bottom line, if your goal is to get out of debt, stop collection calls, and feel like you can breathe again, debt settlement or debt negotiation may only worsen your financial and credit situation. There are other options that can help you achieve what you want now.
Call a credit counselor and ask about a Debt Management Plan (DMP). Every year thousands of people use a DMP to help stop collection calls, set-up one monthly payment to all of their creditors, avoid garnishments and legal fees and to relieve stress. Use the chart below to view (click on the chart for a larger view) the differences between debt management plans and debt negotiation plans. Then pick up the phone and call one of our certified credit counselors to learn what options are available to you to solve your money troubles.