How Does Debt Settlement Work?

Imagine a scenario where you’ve been living a lifestyle that supports your family, you’ve made wise financial decisions, and you have a bit of extra room to do things that you enjoy, maybe a hobby or an annual vacation with your entire family.  

Now, all of a sudden, you’re hit with an unknown circumstance that lands you out of a job, your finances fall apart, and you find yourself taking out loans, leveraging the equity on your house, and completely changing your life’s just to keep your head above water.

This is, unfortunately the reality for millions of Americans who, through no fault of their own, find themselves drowning in debt that they did not see coming nor were they prepared for. There is nothing to be ashamed of when looking at debt you could not have avoided, and there are ways to get yourself and your family back on track.  

In this article, let’s explore the concept of debt settlement, learn how it works, and learn how to decide whether or not it’s the right decision for you to make depending on how deep you may be.

What is Debt Settlement?

Debt settlement is usually a process completed by a for-profit company that works with the company or financial institution that you owe money to to negotiate a settlement (usually a lump sum paid all at once) toward the debt amount that you owe.  

So, instead of paying out regular sums of money over a long period of time (like making monthly payments on a credit card), with debt settlement, you end up paying a much smaller amount in total, but a much larger amount at a single time.  

Typically, since you will obviously not have a large sum of money all at once when you begin talking to a debt settlement company (otherwise, you’d just use it to pay down your debt), a debt settlement professional will have you set aside a large portion of your income each month in order to accumulate enough to pay off your settlement all at once, building up late payments and bringing down your relationship with your lender until they’re willing to settle. 

The Positives of Debt Settlement

Obviously, you should not make a financial decision as impactful as debt settlement unless you understand the pros and cons and feel comfortable making that decision.  

Here are some of the positives that are associated with the concept of debt settlement:

Getting out of debt. This is the number one positive, and one that you should strongly consider when looking into debt settlement in the first place.  Coping with debt stress and unpaid bills can be absolutely crippling to your financial situation, and it can cause you to feel hopeless because so much of Western life is oriented around financial stability and financial freedom.  

While you have plenty of other options for coping with debt such as creating a budget, changing your lifestyle, and aggressively focusing on paying down that debt (especially high interest debt such as credit card debt), debt settlement may be a good option because it enables you to  negotiate a way out of debt and you end up paying a much lower amount overall.

Helps consolidate loans and debts. Another way to consider debt settlement is to look into the concept of loan consolidation settlements, which are basically a large loan that helps you pay off your other loans.  This enables you to manage things like credit card payments, personal loans, and auto loans while still staying on top of your cost of living each month.

pros and cons to debt settlement

The Downsides to Debt Settlement

Realistically speaking, there are far more cons associated with debt settlement than there are pros, which is why debt settlement is often seen as an absolute last resort. 

Here are the biggest negatives associated with debt settlement:

Debt settlement companies are for-profit companies.  Most of the time, they do not have your best interest in mind and they are more worried about making money than actually helping you out and helping you and your family get out of financial difficulty.  This can manifest itself in several ways, including high fees and high percentage rates in what you pay them for their services. 

Debt settlement companies typically want you to stop payment on all of your loans to get you the best chance of a good settlement.  This can be a great idea if you are able to get a good settlement, but completely cutting off contact with lenders who hold your debts can cause creditors to come after you, and you can incur legal fees while trying to deal with civil suits.  Additionally, if you stop making payments, the accrual of late payment marks and nonpayment marks on your credit will significantly bring your score down. 

Some credit agencies, credit companies, and banks refuse to work with debt settlement companies.  Debt relief agencies are not necessarily banks or a financial institution, they’re just a business, so your creditors are not guaranteed to work with the debt settlement agency that you select, putting you at risk for not ending up with a solution even after sacrificing your credit to nonpayment. 

Debt settlement can ultimately cause you to be deeper in debt than when you started, because depending on which debt settlement agency you select, their policy may cause you to incur high interest fees on your original debt, causing you to potentially pile on even more debt onto the initial amount.  

Things to Avoid When Choosing a Debt Settlement Company

WIth all those downsides, are there even any reasons to choose debt settlement?  Well, yes, the debt settlement route may still work for some people, given the ability to choose the correct company to work with.  

If you know specifically what to avoid, you’re much more likely to be able to make the right decision and save yourself trouble down the road.  

Here are some of the most common things to avoid when deciding whether or not to look into a debt settlement program.  

Make sure you select a company that does not charge hidden fees before agreeing to settle your debts with your creditors.  Up-front fees are usually a sign of poor practice and an unwillingness to make their money the hard way, so try to avoid companies that charge up front.

Make sure they do not make any guarantees for any specific percentage reduction or that they can make your debt completely vanish.  Any claims to this effect are completely untrue and are indicative of a red flag. Similar to this are claims that unsecured debts can be settled for “pennies on the dollar”, as these are also just a marketing technique and are untrue as well.  Any up-front guarantees made before your specific situation is made clear are completely false. 

Remember that for-profit financial firms will often put their best interests ahead of yours, meaning that you could find yourself out on a limb with nowhere to go if you pick an agency that doesn’t care about you as an individual.  An alternative to that would be a non-profit consumer credit counseling service, which will work directly with you to find a debt management plan that you can afford rather than trying alternative methods to get your debt negotiated or settled.

Debt settlement: Final Thoughts

Debt settlement may be just what you’re looking for, but make sure you understand what you’re in for.   

By reading this article, hopefully you feel more confident about making a decision for or against the concept of debt settlement.  Whatever works best for your financial situation is always the best course of action; do not hesitate to contact a tax advisor, attorney, financial planner, or other financial professional to discuss specifics before making a decision.

Just keep in mind that debt settlement is not debt erasure, and so it’s important to note all of the potential downsides to making a debt consolidation or debt settlement decision.  

At the end of the day, as long as you see a benefit and your financial situation is improved, you’re probably making a good decision.  However, if the process of debt settlement is frightening, remember that the best time to make financial changes and lifestyle changes was yesterday, and the next best time is right now.