Understanding Debt Settlement

Debt settlement is another option for anyone having difficulty repaying their credit card debts. While on the surface it seems somewhat similar to a debt management plan, how it works and what it does are both very different. Here's what you need to know about debt settlement.

How debt settlement works

A structured debt settlement plan usually looks like this:

  • You pay the debt settlement company rather than your creditors
  • Your debts, meanwhile, are not paid; instead the settlement agency holds your money
  • Your debts become delinquent, and are eventually charged off by the creditor
  • The charged off debt is either moved to an internal collections department or sold to a third party debt collector
  • Finally, the debt settlement company uses the money they’ve collected from you to negotiate a partial payoff (or settlement) of the debt

This works because debt collection agencies purchase debts for less than their original value. The quicker they can collect on a debt, the better the profit margin. So when the debt settlement company comes in ready to make a large one-time payment, the collection agency is usually willing to make a deal.

Benefits of debt settlement

Debt settlement can save you a substantial amount of money. They can also get you out of debt much faster than simply making your regular required payments each month. Working with a settlement agency can also simplify repayment, as you'll only be making a single monthly payment to your settlement agency and not your multiple creditors.

Disadvantages of debt settlement

Settling on your debt requires that you allow your accounts to become severely delinquent, missing months of payments. These delinquencies will likely have a significantly damaging impact on your credit score - assuming your score hasn't already been affected by prior missed payments.

Settlement companies are not free. You may be charged based on the size of your debt or the size of the savings you received by settling. And unfortunately, because settlement requires you to pay upfront before receiving assistance, settlement fraud isn't uncommon. You need to make sure the settlement company you've chosen is reputable and not a scam.

It's also important to note that in most cases the IRS views forgiven debt as income, so you'll be required to pay taxes on that money. This means that if you were in debt $10,000 and settled for $6,000, the IRS would consider the other $4,000 income, which you would need to account for when preparing your annual tax returns.

DIY Debt Settlement

If you’re tempted to go the route of debt settlement, keep in mind that all of those actions are ones you can take on your own. You can divert your potential credit payments into a savings account and allow your debts to go into default. Then you would take the funds out of savings and begin negotiations with the debt collector.

Handling a debt settlement on your own would save you all the fees normally paid to the settlement company. The flip side is that you’d have to handle all the negotiations directly with your debt collectors, which is unlikely to be a positive experience.

Of course, in either scenario, your debts are going unpaid for months and are eventually charged off, which means that your credit is going to take a pretty heavy hit. Debt settlement is not an easy course to take, so be sure you understand all of your options beforehand and that you’re comfortable with the consequences of whichever plan you decide to take.