Debt settlement: Pros and cons

Debt settlement is a service offered by third-party companies that try to reduce your debt by negotiating settlements with your creditors or debt collectors. But there are risks involved.

Although it may be tempting to use a debt settlement service to reduce your debt, it’s important to keep in mind that you could end up deeper in debt or with a negative impact to your credit.

Here’s some key information you should know about how debt settlement works, its pros and cons, and how it could affect your credit.

• How debt settlement works
• Pros and cons of debt settlement
• Alternatives to debt settlement
• Next steps if you want to go ahead with debt settlement

How debt settlement works

Debt settlement companies may also be known as “debt relief” or “debt adjusting” companies. The companies generally offer to contact your creditors on your behalf, so they can negotiate a better payment plan or settle or reduce your debt. They typically charge a fee, often a percentage of the amount you’d save on the settled debt.

Learn more about different types of debt relief and how they work.

The company may try to negotiate with your creditor for a lump-sum payment that’s less than the amount that you owe. While they’re negotiating, they may require you to make regular deposits into an account that’s under your control but is administered by an independent third-party. You use this account to save money toward that lump payment.

While they negotiate, the debt settlement company may also advise you to stop paying your creditors until a debt settlement agreement is reached.

Once the debt settlement company and your creditors reach an agreement — at a minimum, changing the terms of at least one of your debts — you must agree to the agreement and make at least one payment to the creditor or debt collector for the settled amount. And then the debt settlement company can begin charging you fees for its services.

Keep in mind that there is no guarantee the company will be able to reach a debt settlement agreement for all of your debts.

Pros and cons of debt settlement

There can be a few pros to debt settlement, but you should carefully consider the potential disadvantages of debt settlement as well.

Advantages of debt settlement

Settling a debt through a debt settlement company could …

1. Lower your debt amount

If you settle your debt and pay a lump sum, typically your overall debt will decrease. As a result, your debt-to-income ratio will increase which can help you when seeking out other financial products.

2. Help you avoid bankruptcy

Debt settlement may enable you to avoid filing for bankruptcy which may put you in a better financial spot. But keep in mind that settling your debt is never a guarantee.

3. Get creditors and collectors off your back

Once an agreement is reached and your debt is settled, you likely won’t hear from creditors or collectors about the debt you already settled. But if you have other debt that goes to collections, creditors and collectors may call you about that debt.

Disadvantages of debt settlement

But the risks may outweigh the benefits.

1. Your creditors may not agree to negotiate

Not only is there no guarantee that the debt settlement company will be able to successfully reach a settlement for all your debts, some creditors won’t negotiate with debt settlement companies at all.

2. You could end up with more debt

If you stop making payments on a debt, you can end up paying late fees or interest. You could even face collection efforts or a lawsuit filed by a creditor or debt collector. Also, if the company negotiates a successful debt settlement, the portion of your debt that’s forgiven could be considered taxable income on your federal income taxes — which means you may have to pay taxes on it.

3. You may be charged fees, even if your whole debt isn’t settled

Debt settlement companies can’t collect a fee until they’ve reached a settlement agreement, you’ve agreed to the settlement, and you’ve made at least one payment to the creditor or debt collector as a result of the agreement. But you could still end up paying a portion of the debt settlement company’s full fees on the rest of your unsettled debts, says Bruce McClary, senior vice president of communications at the National Federation for Credit Counseling.

“If you have five or six creditors and the company settles one of those debts, they can start charging a fee as soon as they receive a result,” McClary says.

And if a debt relief company settled a “proportion” of your total debt enrolled with its program, it can charge you that same proportion of its total fee. For example, if your total debts came to $10,000, and a debt relief company settled $5,000 of the total amount, it’s allowed to charge 50% of the total agreed-upon fee.

4. It could negatively impact your credit

A debt settlement company may encourage you to stop making payments on your debts while you save up money for a lump-sum payment. But at this point, your creditors might not have agreed to anything, which means all those payments you’re missing can wind up as delinquent accounts on your credit reports.

Your credit scores could take a hit as a result of any delinquent payments, and the creditor could also send your account to collections or sue you over the debt.

Debt happens for many reasons. Learn how to manage debt in five steps.

Alternatives to debt settlement

1. Negotiate your own settlement

Try negotiating settlements with credit card companies or other creditors on your own. Offer an amount that you can pay immediately, even if it’s less than what you owe.

2. Transfer balances

If you have credit card debt, consider a balance transfer. A balance transfer is when you move debt from one credit card to another, usually to take advantage of an introductory 0% interest offer on the new card.

Balance transfer cards typically have one of these 0% intro APR offers for a specified period of time and may charge a fixed fee or a percentage of the amount you transfer.

To figure out if a balance transfer is a good idea for you, check whether you’ll pay more money on the interest payments on your current card than the cost of any balance transfer fees. And you should also try to pay the balance off before the card’s promotional period expires to avoid paying interest on your balance.

3. Seek nonprofit credit counseling

Nonprofit organizations may provide credit counseling services that offer free or low-cost advice on budgeting and debt management. Credit counseling agencies don’t typically negotiate to reduce debt. But a credit counselor may work with creditors on payment plans or to stop late fees or efforts like collection calls.

Next steps if you want to go ahead with debt settlement

Picking the right debt settlement company can help you move towards financial freedom. Make sure to utilize these resources to help you find the best debt settlement company for your needs.

Do your research. The Federal Trade Commission helps protect consumers by trying to prevent unfair business practices in the marketplace. The FTC has useful information on debt that’s worth looking into as you consider debt settlement options.

Pick a reputable debt settlement service provider. Before you enroll in any debt settlement program, the Consumer Financial Protection Bureau recommends contacting your state attorney general and local consumer protection agency to check whether there are any complaints on file. The state attorney general’s office can also check if the company is required to be licensed and whether it meets your state’s requirements.

The Better Business Bureau has consumer reviews of businesses that could help you as you research a debt settlement service provider.