Debt Settlement

Debt Settlement
Debt settlement occurs when a lender or collections agency agrees to settle a debt for less than the amount that the borrower owes.

How does Debt Settlement work?

With debt settlement, borrowers pay off a debt for less than the amount they owe. For smaller debts—those under $5,000—creditors might be willing to settle for 65 percent of the amount owed. For larger debts, creditors usually demand higher amounts—80 to 85 percent of the outstanding debt.1

Creditors agree to debt settlement because the borrower is deemed unable to pay off the full amount, so they are willing to take what the borrower can afford.

Some types of debt—such as student loans, taxes, and child support or alimony—don’t qualify for debt settlement. Also, creditors are not required to negotiate a debt settlement. If they have reason to believe the borrower has the funds to pay the debt, they are within their right to refuse to settle. If this happens, borrowers can try instead to negotiate a lower monthly payment.

How does Debt Settlement affect credit score?

After a debt settlement, borrowers can expect to see their credit score drop. The exact amount of damage largely depends on their original score, with those possessing better ones suffering more severe consequences. For instance, a person with a FICO score of 680 would lose between 45 and 65 points after a debt settlement, but a person with a credit score of 780 would lose between 140 and 160 points.2

In addition, creditors usually only allow debt settlement with borrowers who are at least six months behind on their payments. This means that it is typically only an option in worst-case scenarios when borrowers are suffering serious financial hardship and have already taken a big hit to their credit score.

How is Debt Settlement reported on a credit report?

Debt settlement is recorded on a borrower’s credit report. A typical description may state: “Debt settled for less than the full amount due.” The account will show a balance of zero dollars, and the date of the settlement will be recorded. Missed payments associated with the debt will remain on the report.3

Can you negotiate a Debt Settlement yourself?

Borrowers can negotiate a debt settlement directly with their creditor. To do so, they contact the lender or collections agency and explain their financial situation. The Consumer Financial Protection Bureau offers a three-step plan for borrowers considering debt settlement:

  1. Learn about the debt.
  2. Put together a realistic repayment or settlement proposal.
  3. Negotiate a realist agreement with the debt collector.4

Are Debt Settlement companies a good option?

Another method of debt settlement is to go through a debt settlement company. Having an experienced negotiator can be helpful, but their expertise comes at a cost. Debt settlement companies handle the negotiation as a third party, and they charge a fee that is usually a percentage of the debt owed or the amount of savings negotiated.1

The Simple Dollar compiles an annual list of the best debt settlement companies, but other, less reputable ones have become notorious for scamming their customers. The Federal Trade Commission suggests that borrowers stay away from companies that engage in any of the following practices:

  • Charge fees before they settle the borrower’s debt.
  • Tout a “new government program” to reduce personal credit card debt.
  • Guarantee they can reduce debt.
  • Instruct borrowers to stop communicating with lenders but don’t explain the serious consequences of doing so.
  • Claim to be able to stop all debt collection calls and lawsuits.
  • Guarantee they can pay off debt for pennies on the dollar.6

References

  1. Clazarony, Lucy. Striking a deal with a debt collector. Retrieved from http://www.bankrate.com/finance/credit-cards/striking-a-deal-with-a-debt-collector-1.aspx
  2. Irby, LaToya. (2016, November 10). How will debt settlement affect my credit score? https://www.thebalance.com/how-will-debt-settlement-affect-my-credit-score-960540
  3. McFadden, Leslie. (2009, July 8). How is debt settlement reported? Retrieved from http://www.bankrate.com/finance/credit-cards/how-is-debt-settlement-reported.aspx
  4. Consumer Financial Protection Bureau. What is the best way to negotiate a settlement with a debt collector? Retrieved from http://www.consumerfinance.gov/askcfpb/1447/what-best-way-negotiate-settlement-debt-collector.html.
  5. Haywood-Queen, Sally, and Herigstad, Sally. (2014, April 28). Retrieved from http://www.creditcards.com/credit-card-news/help/8-myths-settling-credit-card-debt-6000.php
  6. Federal Trade Commission. Settling Credit Card Debt. Retrieved from https://www.consumer.ftc.gov/articles/0145-settling-credit-card-debt