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What is Debt Settlement?

Written by Nickel - 12 Comments

Debt settlement. I’ve heard this term over and over in recent months. While I’ve had a vague idea of what this means, I’ve never known exactly what debt settlement entails, so today I thought I’d take a closer look.

Debt settlement in a nutshell

Debt settlement involves negotiating with a creditor to agree on a reduced balance that will be accepted as payment in full. In short, if you fall behind on your payments, your lender(s) might be willing to cut a deal to get at least a portion of their money back in a lump sum payment.

Debt settlement is typically only an option for unsecured debt, such as credit cards, and lenders usually won’t even broach the subject unless you’re already behind on your payments. If that’s you, then debt settlement might be a viable option.

How to settle a debt

While individual consumers can settle a debt on their own, or use an attorney acting on their behalf, debt settlement companies have become increasingly common in recent years. If you’re interested in settling a debt yourself, and you’ve saved up a lump sum to offer as a payoff, then you can contact the lender and try to cut a deal yourself.

Many consumers who opt for debt settlement don’t have a lump sum of cash on hand. In such cases, debt settlement companies will set up an account to receive deposits on the consumer’s behalf such that they can build up the necessary lump sum. Once the consumer has enough funds on hand, the settlement process can begin.

The debt settlement company will contact individual creditors and work to negotiate a reduced payoff. The incentive to the creditor is that they’ll received at least a portion of what is owed rather than having to engage an external collections company, or losing out in a bankruptcy filing.

The downside here is that debt settlement companies charge exorbitant fees for their service. In most cases, this is charged either as a percentage of your total debt (i.e., the more debt you have, the more they charge), or as a percentage of amount of debt forgiven (i.e., the more you save, the more they charge).

The dangers of debt settlement

As always, there is no such thing as a free lunch. Aside from the possibility of fraud on behalf of the debt settlement company, here are some possible downsides to debt settlement:

  • Credit score effects. Not surprisingly, debt settlement will have a negative impact on your credit score.
  • Income tax consequences. While a debt settlement can save you a good amount of money, the portion of your debt that is written off will need to be reported as taxable income.
  • Lawsuits. When they first get contacted by the settlement company, your creditor (or their collection agent) might immediately sue for the amounts owed.
  • Legal considerations. Twelve states actually have laws banning for-profit debt management, meaning that the services of debt settlement companies might not be legally available where you live.

Debt settlement stories?

If you’ve ever been through the debt settlement process, or know someone who has, please share what you’ve learned in the comments section.

Published on November 30th, 2009 - 12 Comments
Filed under: Debt Reduction

About the author: is the founder and editor-in-chief of this site. He's a thirty-something family man who has been writing about personal finance since 2005, and guess what? He's on Twitter!

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12 Responses to “What is Debt Settlement?”

  1. 1
    John DeFlumeri jr Says:

    That is a helpful and well-written explanation of the process. Thanks for writing it.

    John DeFlumeri Jr

  2. 2
    Dan Says:

    Back in the “old days” I had a few accounts go to collections when I lost a job. I tried working with a credit counseling company, but was not happy with the results. Apparently, my debts were getting paid by them, but they were taking a cut of my monthly payment, plus an up front payment. I saw no evidence to suggest that I was “benefiting” from the lower interest rates that they claimed they were getting from me. So, I stopped the ACH transfers to them. (Ack, but my bank was good about it.)

    So, my largest creditor’s collection agency ended up making me a decent settlement offer… about 30% off. I hit up my parents to loan me the money to take care of if it, and they did.

    One thing to note about the taxability of the forgiven debt: If you are insolvent (debts are greater than assets) the IRS will not require you to actually pay taxes on that income. However, if you do become solvent within the next 5 years, you are then liable for those forgiven taxes.

    I’m working off of memory on this one, and my experience was in 2002-2003. So there may be some inaccuracies in what I wrote.

  3. 3
    K at Resqdebt Says:

    Nickel, thank you for this very fair-minded and informative overview. As a debt settlement company, we know that isn’t always the case in the media.

  4. 4
    Damon Day Says:

    Hello Nickel,

    This is a pretty good general overview of settlement however, one thing stuck out. You mentioned that most settlement companies charge a percentage of the amount of debt forgiven. This is actually the opposite. Most companies charge a flat fee based on a clients total debt.

    You were certainly correct though when you called them exorbitant. A typical company will charge a consumer 15% of their total debt as a fee and usually collect that entire fee before they really do any of the work.

    A warning to consumers. I can comfortably say that 95% of the programs out there, blatantly do things that are not in the best interests of consumers. The FTC is currently considering a ban that would prevent companies from charging these types of ridiculous fees upfront.

    According to The United States Organization for Bankruptcy Alternatives (USOBA), this ban could put 85% of companies out of business and leave existing clients high and dry.

    As a consumer it is extremely important that you do not enroll into any sort of program that charges all of the fees before doing most if not all of the work.

    This goes without saying in any industry, but in debt settlement especially.

    Caveat Emptor.

  5. 5
    Dan Says:

    Oh, btw, I’m usually for the government staying out of people’s business and regulating as little as possible.

    But in this case, I’m all for it. In this arena there is very little information for a person to make an informed decision, and people getting collection calls and lawsuit threats are desperate — willing to believe anybody who tells them what they want to hear.

    In other areas of personal finance, I’m willing to let people pay the stupid tax. For instance, in banking, your NSF fees allow me to have free checking. If you are “protected” then I have to pay, and I’m not totally cool with that.

    But with debt settlement and management companies, their entire client base is desperate. And it’s too easy to prey on desperate people when they are told what they want to hear. So regulate the hell out of it, because I don’t think this does much for the free market.

  6. 6
    Brian Says:

    All debt settlement companies that are members of The Association of Settlement Companies (TASC), which is the industry’s regulator—have negotiated and continue to negotiate with the major credit card companies and financial institutions.

    While your creditor may publicly deny working with third-party debt settlement companies, a TASC member is regulated and audited, and must provide an accurate assessment of its ability to negotiate with your specific creditors.

    Debt settlement is not right for everyone, but for an appropriate financial profile, it can be the least expensive and fastest alternative to bankruptcy with the shortest long-term effect on your own credit viability.

  7. 7
    Damon Day Says:

    Hello Brian,

    I must respectfully disagree with your assertion that TASC is the “industry’s regulator.” One might likely assume by reading your comment that TASC is some sort of governmental regulating body when in fact it is a trade association made up of Debt Settlement companies. Claiming a group of debt settlement companies are the industry regulators is pretty much akin to saying that the fox is the best candidate to guard the hen house. Is it not?

  8. 8
    Patrick Says:

    When I was 22 years old I found myself married with a 3 year old son and $25,000 in credit card debt and a job that only paid $18,000 a year. It doesn’t take a math genius to figure out that my debt to income ratio was well past the acceptable range.

    Instead of doing some research, and asking for help from my family in an honest mature way I resorted to a late night phone call to a debt settlement company. They told me that they would reduce my debt by 40% and stop the calls from the credit card companies. At the time I contacted the company I had been making the minimum payment to each credit card on time and even though I was maxed out my credit rating was not completely horrible due to missed or late payments. But, once I started on the plan as they called it I sent them a check for $200 odd dollars a month which they would then pay off my accounts.

    What they didn’t tell me was that the first six payments were just my fee for using the program, which meant that I now had 6 months of no payments on my credit cards which was reported as missed payments. In that half year my credit score dropped over 150 points, I had paid out over $1,200 dollars and wasn’t any closer to being out of debt than when I started.

    Finally I broke down and talked to my older brother who is a C.P.A and gave him all my information and the company name. He made some phone calls, contacted a lawyer for me and within a month the debt settlement company returned all my money to me. The lawyer also contacted all my credit card companies, explained the situation and they all removed the negative marks on my credit score, dismissed all the interest charged during the previous 6 months and lowered my interest rate to a flat 6% on every account.

    I then did the snowball approach to paying off debt and was able to pay off all the debt on my own in two years. I am now completely debt free and only have one active credit card. I think that everyone should be warned of the true cost of using a credit card and then we wouldn’t have suffered as a nation with the subprime and credit crisis.

  9. 9
    Cassandra Says:

    My husband and I worked with a debt settlement company in 2001 when, shortly after we were married, he was laid off.

    Thanks to youthful stupidity, I had ended up with $40K+ debt after divorcing my ex and was still holding most of it when the layoff occurred. We still hadn’t quite learnt our lesson about debt and spending everything we earned at that point, so we had nothing in savings to cushion our fall. We were two very frightened young 20-somethings.

    I did a lot of research and ended up calling a debt negotiation company to see how they could help us. I was comfortable with their plan (the monies remained in our bank accounts and they kept us completely involved in the negotiation process although they handled the creditors on our behalf) and with their assistance, we paid off every cent of our debt. I realise now we could have done this ourselves, but we were young and scared (and really, quite ashamed) and at the time felt that working with this company was our best option.

    I work for an accounting firm, so the tax implications of settling so much debt were thankfully spelled out for me very clearly and we did not have to worry about that end of things (we were definitely insolvent). Our credit did take a bit of a beating, but it really wasn’t as terrible as we had anticipated. While it was sobering, we both had very good credit prior to the layoff and taking action shortly thereafter and paying everything off in about 18 months allowed us to recover rather quickly and we qualified for a good mortgage in May of 2004.

    To this day, we are not sorry for choosing the debt settlement path. We consider the fees we paid to the debt negotiation company (a percentage of what we saved, not what was paid) and temporary damage to our credit reports as tuition for an incredibly painful learning experience, but one that is still with us today. And thank goodness! Despite an MBA and several years’ experience, my husband was once again laid off in Sept 09 (unfortunately, we live in Michigan). This time, we have a decent emergency fund (which we have not had to draw on yet after making several cuts to our budget–cuts we intend to keep in place even after things get better) and more common sense. I’m pretty sure we’re going to weather this storm just fine.

    My only advice, should you find yourself in a similar situation, is to work with the creditors yourself if you can but if you can’t, DO YOUR RESEARCH and find a company you feel you can trust to help you out if this practice is allowed in your state.

  10. 10
    Debt Settlement Company Says:

    Financial Management is a pioneer in the debt settlement industry and has … Conniving Credit Card Companies.

  11. 11
    Grace Says:

    Like many of the folks who commented on this post, my husband and I also went through debt settlement after my husband and I both got laid off and found ourselves with mountains of debt. We opted to do it on our own because my research told me we would save more and would have better control of the negotiation process if we negotiated with our creditors ourselves. We had to have nerves of steel and sport poker faces during negotiations because some of the collectors were downright nasty and mean, but we expected it. At the end, we settled all our credit card debt at an average of 45%, saving 55%, so we were happy with that. (My settlement offers started at 10% and they started at 85% so you can see we met right around the middle). We could’ve done better but the collectors could see that we had other assets through other mortgages (on rental property) on our credit report that were current. They drove a hard bargain and 2 creditors actually sued us. We feel doing it on our own was the right decision for us, but if you are faint of heart, hate confrontation, and are not confident about your negotiation skills, you may want to seek help very very carefully.

  12. 12
    Dean Says:

    I have researched debt settlement companies and still don’t know how to tell who to use. One told me my monthly payment would be $1,200 a month (a christian counciling company), another told me $526 month and another told me $365 month. The last one told me they were certified with the TASC and something else. This one also told me I would pay a percentage and that they would take other fees out at the end so that payments would start as soon as it was set up. The $365 still isn’t posible until I find a job, but when I did the math it was saving me more than 50%. Does this sound too good to be true? I don’t know who to believe or trust. Is there a way to find out who’s legit?

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