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Debt settlement occurs when a debtor successfully negotiates a payoff amount for less than the total balance owed on a debt. This lower amount is agreed to by the creditor or collection agency and is fully documented in writing. Ideally, this lower negotiated amount is paid off in one lump sum, but it can also be paid off over time. Negotiating and paying lower amounts to settle debts is far more common than many people may imagine.
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Types of Debts Eligible for Settlement
Why Would a Bank Settle Debt for Less?
At first blush, it may appear surprising that banks would be willing to settle for less than what is owed them. However, banks are aware of the statistical certainty that not all borrowers to whom they extend credit will pay them back.
This bank’s carefully formulated lending model accounts for defaults. Knowing this makes it easier for a debtor to understand that there are numerous opportunities available for settlement.
From a bank’s perspective, as an account grows more and more delinquent, the probability of receiving even one more payment on it progressively diminishes.
In fact, roughly 80% of all accounts that go unpaid for more than ninety days and are then dispatched to collection agencies, law firms, or sold to debt buyers never result in any further payments being made on them.
Banks and other creditors, therefore, are focused on losing as little as possible, recognizing that taking a smaller piece of the pie is better than not receiving anything back at all.
The Basics of Debt Settlement
One of the basics of settlement is to focus primarily on unsecured debt, such as credit cards. This type of debt is known as unsecured because there is no collateral behind it that can be seized in the event it goes unpaid. Now, when it comes to deciding which cards you should settle, there are several things to consider and to be aware of.
Importantly, be aware in advance that debt settlement will only take place on an account in which you have already fallen behind three months or more. In fact, the best savings are often realized when an account is closest to charge-off status and a bank is eager to negotiate and collect a settlement.
Because it takes several months of missed payments for an account to approach charge-off status, it is best to leave cards with low balances of $1,000 or less out of any settlement plan.
This is because the late fees that accrue with the resultant higher interest rates that often result from missed payments will disproportionately raise the debt balance on a percentage basis. This often makes any eventual settlement close to a break-even (or worse) than your out-of-pocket costs would have been had you simply maintained making relatively small payments while doing no further damage to your credit score.
However, if you have small balances that are already charged-off, then you should include these in your settlement plan, as the balances have already risen due to late fees and the damage to your credit score has already taken place.
Debt Settlement
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How the Debt Settlement Process Works
At the outset, decide whether you possess the background, wherewithal and fortitude to negotiate directly with creditors yourself, or whether engaging the services of an experienced and reputable debt settlement company will serve your needs best.
Remember, the goal is to save the most money (and time) while minimizing the damage to your credit profile as best as possible.
Often times, a highly skilled debt settlement company will meet these objectives best. You’ll also need to begin putting aside money for eventual payment. Saving enough money for your settlement payments could take a while – as long as three years.
Along the way, either you or your settlement company will contact your creditors and work toward a lower payout structure on your debt.
What Happens to my Credit Score and Profile?
Debt Settlement will impact your credit profile adversely, there’s really no way around this reality. When you stop making payments on accounts, your credit score and profile suffer, and as your accounts fall deeper into delinquency, that impact continues.
If the creditor ultimately reports the debt as a settlement to the three major credit bureaus (Experian, Equifax and TransUnion), it will remain on your profile for seven years. However, it is also possible to have a creditor report a settled account as “paid in full,” and this minimizes impact to your credit score.
Regardless, as you make consistent payments into an escrow account managed by your debt settlement company representative, the damage to your credit score will diminish and eventually plateau. Even better, once your settlement balances have been fully paid, your credit score and profile will head toward improvement with continued responsible behavior on your part.
Different Types of Debt Negotiation
Individual credit card lenders typically have internal policies that vary from bank to bank when it comes to managing collections on delinquent accounts. Some will offer temporary or long-term hardship programs in which the interest rate and/or monthly payments can be reduced for a period of time ranging anywhere from three months to five years.
Meantime, some cards will prove more aggressive than others with debt collection efforts through their own internal recovery departments.
Furthermore, when an account goes delinquent for more than 180 days, it is common for that account to reach charge-off status and be turned over to an outside collection agency for recovery.
Additional options for the creditor include turning an account over to a debt-collection attorney or selling the legal right to collect to a debt buyer. Debt settlement aims to resolve any of the above situations while allowing the debtor to pay less than the current balance on the debt.
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Subtleties to be aware of during debt negotiations
The existence of balance transfers on your card balance can impede the effectiveness of any potential settlement. Both the recency and size of balance transfers are considered. Banks may frown upon settlement (or raising the percentage of debt owed that they may ultimately accept) on accounts that show balance transfer activity within 12-24 months of when payments stopped being made or when the percentage of balance transfers held on the card approaches 20% of the total card balance.
Similarly, cards that show aggressive recent purchasing activity will likely be less eligible for settlement. In these type situations, it can make better sense to wait to settle with an outside collection agency than with the original creditor bank that issued the card.
It may also make sense to keep one or more of your accounts open. Part of keeping a reasonably healthy credit score is maintaining open and active revolving accounts within your credit profile. Keeping open one or two accounts with low balances that you can then use responsibly will help mitigate the damage that settlement on other accounts may do to your credit score.
Don't Pursue Debt Settlement Too Soon
A basic fundamental to debt settlement is that creditors won’t show a willingness to settle until the debtor has already demonstrated an inability to pay.
If you fall behind on payments temporarily as a result of a relatively brief rough patch, then the debt settlement process might not be your best option, given it’s irreversible quality once it has begun and the negative consequences it can have on your credit profile. Individuals in this situation should consider a credit counseling service or investigate short-term hardship plans that a creditor bank could make available.
However, if you’ve already fallen behind on payments by four or five months and there isn’t much light showing at the end of the tunnel, it could be time to start negotiating directly with your bank for the best settlement before it assigns your account to a collection agency. This is often the sweet spot in terms of timing – the bank still controls your account but also knows that the clock is ticking closer to charge-off, the point at which it would likely never recover anything from the account again – and your credit score takes a hit.
This moment in time is a win-win for all involved – the debtor pays less than is owed while limiting credit score damage, and the creditor loses the least by recovering some value from a delinquent account that would otherwise be recognized as a loss on its books.
Get Your Debt Settlement Documented in Writing
It is important to understand that a settlement agreement is not fully closed until it is agreed upon in writing. In other words, a verbal agreement with a creditor simply is not enough.
Reaching a settlement agreement rarely happens in a single phone call to a creditor, rather, it usually evolves over several well-placed calls spanning several weeks or months.
However, once a deal has been struck, be certain to get all of the following critical information drafted into a dated settlement letter:
- Your Name and Account Number,
- The name of the Creditor/Collector,
- The outstanding balance on the account and the amount agreed to as settlement,
- The terms of the payment (lump sum vs. periodic payments over time) along with payment due dates, and, finally, a clear written statement indicating that the account has been satisfied in full.
What to Look for in a Debt Settlement Company
A reputable debt settlement company will never guarantee a specific settlement amount, but rather, it will provide a realistic estimate and time frame for making offers to creditors that can ultimately result in settlements that save you significant amounts of money.
Since creditors actually have no legal obligation to settle, any debt settlement company that goes so far as to guarantee settlement is acting dishonestly.
When contacting a debt settlement company, expect all fees and costs to be disclosed up-front, and look for clear written guidelines regarding their debt resolution program. You should be provided with an estimate of how much time may elapse before settlement offers are made on your behalf, and how much money you must save up before these offers will be made.
Finally, make certain that the settlement company has a practice of sending all settlement offers to you, its debtor customer, for your approval, prior to them being sent to creditors.
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Should I use a Debt Settlement Company?
A reputable debt settlement company staffed with experienced credit counselors who have relationships with major credit card lenders and an understanding of the marketplace can help you wade through these waters.
A settlement company can also advise you as to how much money you should put aside in advance of negotiations and set up an escrow account in your name that will be managed by a trustee or administrator.
Depending on your individual budget constraints and size of your settlement, you will make regular monthly payments into this FDIC insured bank account for several months or years until your debt is fully paid. However, there are a few more things to consider.
Debt settlement companies often charge a fee equal to 25% of the amounts saved in your settlement, or 15% of the original total debt load.
Additionally, the IRS recognizes forgiven debt as taxable income, so if you save anything over $600, you will have to pay taxes on it. Be especially wary of any debt settlement company that promises to settle your debt for “pennies on the dollar.”
With rare exceptions dating back to the financial crisis of nearly ten years ago, these claims have almost always proven too good to be true.
Debt Settlement FAQ
What is debt settlement?
Debt settlement can be a good idea when a debtor has already fallen behind on a number of different credit card accounts. Creditors recognize that delinquent accounts that are approaching charge-off status may eventually become worthless to them, and are often willing to accept less than the total balance owed as a result. A debt settlement firm may be able to successfully negotiate a lower balance payoff – and even get the creditor to mark the account as “paid in full” on a credit report, though creditors are under no legal obligation to accept settlement offers.
How long does debt settlement stay on your credit report?
Debt settlement remains on a credit report for seven years. Settling an account for less than the full balance owed is considered potentially negative, as it implies that a debtor did not repay the entire debt as stipulated under the terms of the original contract. Though large settlements will have a proportionate negative impact upon a credit score and profile, it is possible that the settlement of small balances will have a negligible negative effect, particularly when an individual is current on other larger loans.
How to write a debt settlement proposal letter?
A written debt settlement proposal letter should be both formal and clear – it must include all identifying information related to your name, address, account number and balance owed, so that a creditor can quickly access your account and cross-reference it with your letter. The letter should describe the circumstances that prevent you from paying in full, along with an offer to pay a specified amount upon acceptance of the offer.
How to negotiate debt settlement?
Negotiating debt settlement yourself can be a lengthy process, but it is something that you should try to complete as quickly as possible. The key to effective debt settlement is possessing the financial ability to settle. Therefore, if you have the means, you should begin saving for an eventual lump sum payment or structured payment schedule that can be completed within two years from initiation. Either you or a settlement company must assess your financial situation and determine how much you can save each month toward your eventual settlement. A good settlement company will approximate how much you will ultimately need following a specific review of your creditors and a determination as to which of them may be potentially legally aggressive. You also must generate a hierarchy of creditors – who to settle with first, and at what percentage – followed by the next creditor and percentage, and so forth, through your entire sequence of creditors. You also must manage all communications with your creditors. Accordingly, you must formulate a strategy of how to best submit settlement offers that paint your situation in the most advantageous possible light and that provides creditors with proper incentive to settle with you.
Can I buy a house during debt settlement?
It is possible to get approved for a mortgage and buy a house during and after debt settlement. The process of debt settlement will often negatively impact a credit score, so it can be the case that credit score repair becomes the first order of business before applying for a mortgage, since qualifying for a home loan from the Federal Housing Administration requires a FICO score of 580 or higher, for example. However, if credit score, payment history and debt-to-income ratio are in an acceptable range, many mortgage lenders will lend to those individuals showing a history of debt settlement.
How does debt settlement affect your credit score?
Debt settlement can have a potentially significant negative impact upon a credit score. Since debt settlement often follows a period of several months of non-payment on accounts, any delinquencies will have already impacted a score negatively. Ironically, when debt settlement is made on accounts in good standing, a credit score will be more negatively impacted, since there haven’t been any black marks that have previously weakened the score. Credit scores are designed to measure an individual’s ability to pay debt balances back in full, and since debt settlement implies an inability to pay balances back in full, it makes sense that debt settlement will have a negative impact on a credit score, particularly when larger settlement amounts are involved.
What is better debt consolidation or debt settlement?
The question of which is better, debt consolidation or debt settlement, is completely dependent upon circumstances. Debt settlement makes more sense when dealing with accounts that are already seriously delinquent – in these instances, much of the damage to a credit score has already been incurred, and although a debt settlement will remain on a credit report for seven years, the prospect of paying less than the full amount owed could be worth the stain, particularly when the account is no longer in good standing. Debt Consolidation makes sense for individuals who can simplify the repayment process by paying off a number of balances through the proceeds of a debt consolidation loan that is often taken out an overall lower blended interest rate, thereby saving money on interest expense while also usually lowering the monthly payment.