Understanding Debt Settlement

The following article is for informational purposes only and is not intended as legal advice. 

If you’re in debt, have fallen behind on your payments, and collection agencies are starting to call, settling your debt may seem like the best option. And it very well could be, but there are some things you should know first. 

What is Debt Settlement?

It's an option for individuals who are struggling to make minimum monthly payments and want to avoid bankruptcy, but may not qualify or benefit from other debt repayment options like a debt consolidation loan or a debt management plan (DMP).

Creditors will almost never settle on a debt that is current. Nearly all settlements involve debts that are severely delinquent, or that have been sold to a debt collection organization. 

How Does Debt Settlement Work?

Debt settlement typically involves these steps:

• Assessment of debt: Evaluate your total debt amount, including interest and fees.
• Creation of a settlement fund: Set aside funds to negotiate with creditors.
• Negotiation: Contact creditors or collection agencies to negotiate a reduced payoff amount.
• Agreement: Reach an agreement with creditors on the reduced amount and payment terms.
• Payment: Make the agreed-upon payment to settle the debt.

In the right situation, debt settlement can be mutually beneficial: the debt holder gets a percentage of the money owed without having to take legal action and the debtor doesn't have to repay the full amount. 

What are the Drawbacks of Settlement?

Not all debt qualifies for settlement

Some of your debt can’t be settled for less than the full balance, including student loans, child support, alimony, and in most cases, secured debt like home or auto loans. Settlements tend to be limited to credit cards debts, unsecured personal loans, and medical bills. Depending on how much you owe to the IRS, you may also be able to reach a settlement to reduce your tax bill. 

There is a statute of limitations on debt collection

There is a statute of limitations on debt, but it’s a little tricky to figure out how that impacts your personal situation. A few important points: 

• Each state sets their own statutes. Most are between 3-6 years, though some range from 2-10 years. 
• Different types of credit may have different lengths of statutes. Even within the same state, the statute of limitations on a credit card, personal loan, and promissory note could all be different. 
• Statutes of limitation have no bearing on your credit history or score. The two are not connected in any way. 

Once the statute of limitations on a debt has passed, the creditor loses certain legal leverage. However, they can continue to attempt to collect the debt and even sue you for the funds. It's your responsibility to understand how your state’s statutes impact your debt and respond accordingly. Consult with an attorney or other qualified professional if you have questions about your specific debts. 

Debt settlement can hurt your credit

As noted, creditors are very unlikely to accept a settlement on an account that’s current. This means that most settlements begin by missing payments – often intentionally. Of course, missed payments aren’t great for your credit, and missing enough payments to cause your account to go into default can be incredibly damaging. 

There’s also the impact of the settlement itself. Remember, your credit score is shorthand – it tells future lenders how likely (or unlikely) it is that you’ll pay them back in full, as agreed upon. When you settle a debt you’re not paying a lender back as agreed upon. So even if the debt is considered “paid” it’s usually marked as having been settled, which can impact your ability to get future credit. 

Of course, if your accounts are already deeply delinquent, there’s a good chance that the potential harm caused by a settlement will be minor (at least compared to the damage that’s already been done). If that’s the case, a settlement may be a sound choice for you. 

Debt settlement and bankruptcy may be avoidable

If you’ve fallen behind on your payments due to a loss of your job or for a medical reason, credit card companies will sometimes allow you to make smaller payments (or skip payments altogether) for a short period of time while you get back on track. You’ll usually still be charged interest at the normal rate during this period, but it can help keep your debt from reaching catastrophic levels. If you feel yourself sliding too deeply into debt, consider speaking with a qualified credit counselor for free advice on how to stabilize your finances. 

Should You Use a Settlement Company?

When you think of debt settlement, you probably think of settlement companies. And the legitimate companies in the debt settlement space do provide an often helpful service. But you don't need to use a third party to negotiate a settlement with your creditors. 

Is it easy to arrange your own settlement? It really depends on who you’re working with. You need to keep in mind that no matter who owns your debt, they want as close to the full value as they can muster. You should also keep in mind, however, that they don’t need you to pay the full balance in order to make a profit. If you’re dealing with a third party debt collection agency, they likely purchased your debt for pennies on the dollar. Some other things to keep in mind: 

You can usually save significant money with a lump sum payment. A payment plan comes with some risk for the debtor – it assumes you’ll follow through and make the required payments (which, you’d have to admit by this point, is far from a guarantee). So many collectors will gladly take a lower percentage of the total debt if it comes upfront, all in one payment. 

Debt collectors want to spend the least amount of time possible talking to you. When a collector purchases your debt, they’re making an investment. Every man hour they spend trying to collect on that debt cuts into their potential profits. This puts at least some of the leverage in your court. Don’t be afraid to negotiate. 

Should you settle debts on your own?

If you’re comfortable haggling, you should be able to manage a debt settlement on your own. In particular, if you're able to make a lump sum payment for 30-50% of the debt amount and your accounts are either in collections or at least charged off by the creditor, you'll likely be able to come to an arrangement.

Perhaps most importantly, if you're able to settlement your debts directly with your creditors you can avoid the various fees that a settlement agency would charge.

Should you use a debt settlement company?

On the other hand, if you find that you’re not getting anywhere or you don’t feel like you can wisely act as your own advocate, you may want to consider hiring a debt settlement company. Because they work with so many creditors on an ongoing basis, they may be able to reach a settlement quickly and for less than what you would have paid on your own. 

Once again, keep in mind that this service is not free. Most settlement companies will charge a percentage of the total debt they are settling for you. The practice also usually requires that you make payments to the settlement company for months before they will take action with your creditors. For a legitimate company this is fine (they need to collect funds in order to negotiate and pay off your debts with one lump sum), but with a less reputable company this could be dangerous.  

Be cautious and do your research before engaging with a settlement company. And if you're not sure if settlement is right for you, consider speaking with a nonprofit credit counselor to discuss your options. MMI offers a debt management plan that can help you repay your credit card debts in five years, and often with a significant interest rate reduction to help make your repayment more affordable.

Curious to learn more? See how debt management plans stack up to debt settlements.