What is debt settlement?

If you’re finding that your debt has become unmanageable, you may be looking at options for paying it down or resolving it altogether. One approach is to establish a debt settlement plan. This isn’t always the right solution, though, so it’s important to assess your financial situation, and then understand the risks and rewards of debt settlement before you determine how to proceed.

Debt settlement allows you to negotiate your debts with each creditor in a way that enables you to settle the outstanding balance for less than you owe. By understanding your debt, learning about the approach each creditor takes to resolving delinquent accounts and then negotiating settlement amounts that are less than the balance on each account, you can create a debt settlement plan to get out from under the weight of your growing debt.  

How to know if debt settlement is right for you

To assess if settlement will work for you,  it’s important to consider:

1. Your balances. Some amounts are too small for settlement.
2. Your creditors. Each company has its own approach to dealing with delinquent accounts and their policies change periodically.
3. Your cash flow. Do you have the funds to settle all your debts within 18 months? Even better, can you do it within 12 months as this reduces the risk of creditors suing you?
4. Can you pay each creditor within the timeline they require and still pay your other bills? There’s no point in settling your credit card debt if you’re risking eviction or repossession of your car.
5. Are there other sources of funds, e.g., something you can sell or loans from family or friends that you can access?

What kinds of debts can be settled?

Most any type of unsecured debt can be settled. For example:

• Credit card debt
• Business and/or commercial debt
• Slow or late payments
• Defaults
• Charge offs
• Accounts placed with a debt collection agency and/or attorney debt collector
• Medical bills
• Deficiency balances
• Store credit card
• Pre-judgment and post-judgment settlements

There are some important reasons to leave certain accounts out of your debt settlement plan. These can include accounts with small balances, those with recent balance transfers or recent high-volume purchases.

How debt settlement works

Once you’re at least 90 days late on your credit card or loan payments, your creditors may be willing to negotiate a settlement. Some are more likely to negotiate after you’ve missed five months of payments. You’ll need to understand the policies for each of your creditors. However, because the statistics show that 80% of delinquent accounts never end up getting paid, banks tend to be motivated to work with you, at least to some extent, to resolve your debt.

The window for getting the best settlement deal is usually after you are three months late but before the creditor charges off your debt, which is typically by the 180^th day that your account falls into arrears. A charge off is when the bank records your debt as a loss. You can still settle past this day, but a charge off has a bigger impact on your credit score.

Related article: What does it mean to have my unpaid debt charged off?

To settle your accounts, you or your representative must contact your creditor (or their representative, such as a collection agency or collection lawyer) to negotiate to pay less than your current balance and agree to a one-time payment or payment schedule.

What to consider when evaluating your settlement plan

To understand if your settlement plans will work for you, you’ll need to consider:

• What your settlement(s) will cost
• How long the settlement plan(s) will take to complete
• When you should target certain creditors
• What service fees are associated with any organization you use to negotiate on your behalf (or you can take a DIY approach as covered later in this article)

Once you commit to your Debt Settlement Agreement with your creditor, it cannot be altered. You must adhere to the terms of the agreement or your debt may not be resolved. For example, missing a scheduled payment may nullify the agreement.

What is an acceptable offer?

Creditors will base their agreed settlement amount on how delinquent your account is, how long you’ve had the account and how collectible you look on paper (i.e., whether you appear to be managing at least some of your debts well). The terms of the settlement will vary and require negotiation.

In his guide “How to Eliminate Your Debts Quickly and Safely Without Filing Bankruptcy,” ZipDebt founder Charles Phelan says: “The goal is to have the creditor forgive at least 50% of what you owe, and hopefully even more.”

Michael Bovee, co-founder of Resolve, added that an acceptable settlement offer is one the consumer can afford to pay.

“Generally speaking, settlements can be reached at 50% and lower,” Bovee explained. “There are, however, situations that will require 50% and higher settlements. Collections in the courts are certainly part of this higher percentage account pool, but there are a few creditors that will often be settled at just above the 50% range.”

Debt settlement pros & cons (including the impact to your credit)

There certainly are benefits to debt settlement in the right circumstances. For those who have debt that has become unmanageable but who do not qualify for Chapter 7 bankruptcy or do not wish to take that approach, debt settlement may be a good option. While there is a negative impact to your credit, if you’re considering settlement, you’re more than likely already late on payments, so your credit is already impacted. And, if you’ve missed payments with your creditor, and are in collections, settling will eventually help your credit and may help you avoid getting sued.

Settling can improve your financial situation once you are out from under your debts, meaning you’ll be able to move on to accomplish other financial goals. You can apply for credit cards, loans and mortgages right after your last settlement payment, for example.

Related article: 5 steps to rebuild credit after debt settlement

However, it’s important to also weigh the risks. In order to negotiate with your creditors, you’ll need to be at least 90 days late on your payments. This does impact your credit. So, if you’re not already late, you may want to consider this impact. And, Bovee cautions, if you have short-term financial goals, such as purchasing a car, co-signing your child’s school loan, etc., debt settlement will not be the right option for you at this time.

Other financial implications can include:

• Taxes may apply to the amount of debt forgiven in your settlements. You should speak with a tax adviser about this.
• Your account will be subjected to internal/external collections, which could include being sued.
• You also must have the money to pay off the debt at the negotiated amount and time because if you miss one payment, your agreement is nullified.

Debt settlement alternatives

To recap, debt settlement impacts your credit score, can limit your ability to accomplish short-term financial goals, does not protect you against being sued and may have tax implications. You need to consider these risks and review your other options for resolving your debt to ensure this is the step you want to take. Some alternatives to debt settlement include debt management, bankruptcy and debt consolidation.

Bovee advises that the first alternative to consider is Chapter 7 bankruptcy because it is the lowest cost and fastest option and, he adds, it’s not the credit-killer it’s often made out to be. If you don’t qualify or you don’t feel it’s the right solution for you, you can also look at debt management. This option won’t have the same negative impact on your credit score, you won’t have to deal with collectors and you won’t be sued. However, debt management is a rigid plan that doesn’t allow for any deviation from the agreement. Therefore, it can be challenging to complete unless you have consistent income for the three to five years the plan will last.

Bovee explains that for some a viable option is to do nothing. If your current finances don’t allow you to both cover your household needs and pay down debt, you may need to ignore the debt. He says, “If you really are broke, then you don’t even have to worry about them collecting something from you after a judgement.”

DIY settlement: How to negotiate your debt for pennies on the dollar

It is possible to negotiate directly with your creditors and pay off your debt for pennies on the dollar. But there is a basic formula to follow in order to maximize savings and limit risks, according to Bovee. He explains that the more creditors you have, the more important it becomes to strategically plan for which accounts to negotiate with first, and which would be better settled with outside debt collection agencies (after charge off).

How you develop your plan should be based on how much money you have available to settle for the best rate of savings given your particular lenders’ policies at the time you are negotiating with them. And you should balance that against any credit cards you have with a lender that is more aggressive in collecting.

You’ll need to be able to handle seeing your credit score impacted by your past-due accounts and manage an onslaught of collections calls. But there are steps you can take to set yourself up for success. You’ll need to:

• Learn about the current policies of each of your creditors for negotiating delinquent accounts.
• Review your timeline for each account to understand how many days past due you are and when you’ll be in the ideal time frame for negotiation.
• Have a realistic understanding of your finances to ensure that you’ll have the funds needed to pay on each agreement at the agreed-upon time.
• Set up a separate bank account for payment of your agreements.
• Ignore collector’s phone calls until you are past due for at least 90 days. Then, at the time you deemed to be “right” per what you learned about negotiating with this particular creditor, contact them when you’re ready to offer a specific settlement amount. (You calling them can give you a sense of control, which is often lost in the barrage of collections calls.)

Negotiating a settlement might take one call or many. Once you reach an agreement, proper documentation is critical. Before you send any money, you must get that agreement in writing.

In some cases, Bovee explains, certain banks require you provide your ACH payment information prior to sending you the agreement. If this happens, it’s wise to record the segment of the call covering the settlement deal. Inform your creditor that you’re recording the conversation because they refuse to send the agreement letter prior to your submitting payment. Hold onto that recording until you receive the written agreement.

He also suggests scheduling the payment 10 days out to allow time to receive the agreement. Then follow up in 72 hours to request it via fax if you’ve not gotten it in the mail. And, if they won’t send it, cancel the scheduled payment and be willing to walk away from the agreement.

Related article: How to negotiate credit card settlement by yourself

Debt settlement agreements

The debt settlement agreement is the settlement contract between you and your creditor that includes all the critical details you have both agreed on – settlement amount, payment plan and date(s), involved parties, etc. If you negotiate your settlement plans yourself, you can use a debt settlement agreement template to create this binding document. You’ll need a separate agreement for each creditor.

In addition to disclosures and text that covers the creditor be sure the following information is included to protect your interests:

• The creditor and/or debt collector’s name
• The date the letter was drafted
• Your name
• Your account number
• Outstanding balance owed on the account (this is sometimes missing and is not a deal breaker according to Bovee)
• Amount that is being agreed upon as a settlement and satisfaction of the debt, which is less than the full amount owed
• Terms and amounts of payments to be made if you’re settling the account over a period of time instead of with one lump sum
• Date your payment(s) must be received by in order to fulfill the settlement agreement
• The settlement agreement must reference that the account is being satisfied in full. This may also be noted as “settled,” “settlement of this account,” “accepted as settlement in full” or “paid in full.”

The challenges of debt settlement companies & plans:

There are a lot of traditional debt settlement companies and not all have your best interest in mind. Most charge high fees for their programs, such as 20-25% of your total debt balance. Many negotiate your accounts in an order that gets them paid faster rather than saving you the most money. There are also many that prey upon people who are in desperate financial situations and offer deals that are truly too good to be true.

While many debt settlement companies out there would have you believe that they have some special inside connections that enable them get a better deal for you, that’s most often not the case.