Understanding Debt Settlement

The following article is for informational purposes only and is not intended as legal advice. 

If you’re in debt, have fallen behind on your payments, and collection agencies are starting to call, settling your debt for less than what you owe may the best option, especially if other debt repayment options are too expensive or don't fit your needs. Before starting the settlement process, here's what you should know. 

What is debt settlement?

It's an option for individuals who are struggling to make minimum monthly payments and want to avoid bankruptcy, but may not qualify or benefit from other debt repayment options like a debt consolidation loan or a debt management plan (DMP).

Creditors will almost never settle on a debt that is current. Nearly all settlements involve debts that are severely delinquent, or that have been sold to a debt collection organization. 

How does debt settlement work?

Debt settlement typically involves these steps:

• Assessment of debt: Evaluate your total debt amount, including interest and fees.
• Creation of a settlement fund: Set aside funds to negotiate with creditors.
• Negotiation: Contact creditors or collection agencies to negotiate a reduced payoff amount.
• Agreement: Reach an agreement with creditors on the reduced amount and payment terms.
• Payment: Make the agreed-upon payments to settle the debt.

In the right situation, debt settlement can be mutually beneficial: the debt holder gets a percentage of the money owed without having to take legal action and the debtor doesn't have to repay the full amount. 

What to consider before pursuing settlement

Not all debt qualifies for settlement

Some of your debt can’t be settled for less than the full balance, including student loans, child support, alimony, and in most cases, secured debt like home or auto loans. Settlements tend to be limited to credit cards debts, unsecured personal loans, and medical bills. Depending on how much you owe to the IRS, you may also be able to reach a settlement to reduce your tax bill. 

There is a statute of limitations on debt collection

There is a statute of limitations on debt, but it’s a little tricky to figure out how that impacts your personal situation. A few important points: 

• Each state sets their own statutes. Most are between 3-6 years, though some range from 2-10 years. 
• Different types of credit may have different lengths of statutes. Even within the same state, the statute of limitations on a credit card, personal loan, and promissory note could all be different. 
• Statutes of limitation have no bearing on your credit history or score. The two are not connected in any way. 

Once the statute of limitations on a debt has passed, the creditor loses certain legal leverage. However, they can continue to attempt to collect the debt and even sue you for the funds. It's your responsibility to understand how your state’s statutes impact your debt and respond accordingly. Consult with an attorney or other qualified professional if you have questions about your specific debts. 

Debt settlement can hurt your credit

As noted, creditors are very unlikely to accept a settlement on an account that’s current. This means that most settlements begin by missing payments – intentionally if your account is current at the time you begin the settlement program. Of course, missed payments aren’t great for your credit, and missing enough payments to cause your account to go into default can be incredibly damaging. 

There’s also the impact of the settlement itself. Remember, your credit score is shorthand – it tells future lenders how likely (or unlikely) it is that you’ll pay them back in full, as agreed upon. When you settle a debt you’re not paying a lender back as agreed upon. So even if the debt is considered “paid” it’s usually marked as having been settled, which can impact your ability to get future credit. 

Of course, if your accounts are already deeply delinquent, there’s a good chance that the potential harm caused by a settlement will be minor (at least compared to the damage that’s already been done). If that’s the case, a settlement may be a sound choice for you.  

You may have more leverage than you think 

Is it easy to arrange your own settlement? It really depends on who you’re working with. You need to keep in mind that no matter who owns your debt, they want as close to the full value as they can muster. You should also keep in mind, however, that they don’t need you to pay the full balance in order to make a profit. If you’re dealing with a third party debt collection agency, they likely purchased your debt for pennies on the dollar. Some other things to keep in mind: 

You may be able to save money with larger payments. A payment plan comes with some risk for the debtor – it assumes you’ll follow through and make the required payments (which, you’d have to admit by this point, is far from a guarantee). So many collectors will gladly take a lower percentage of the total debt if it comes quickly, in fewer, larger payments. 

Debt collectors want to spend the least amount of time possible talking to you. When a collector purchases your debt, they’re making an investment. Every man hour they spend trying to collect on that debt cuts into their potential profits. This puts at least some of the leverage in your court. Don’t be afraid to negotiate. 

Should you settle debts on your own?

If you’re comfortable haggling and staying organized, you may be able to manage a debt settlement on your own. You'll need to be diligent and it may be somewhat time-consuming, especially when you're starting out, but DIY settlement is perfectly doable. 

Should you use a debt settlement company?

On the other hand, if you find that you’re not getting anywhere or you don’t feel like you can act as your own advocate, you may want to consider hiring a debt settlement company. Because they work with so many creditors on an ongoing basis, they may be able to reach a settlement quickly and for less than what you would have paid on your own. 

Keep in mind that this service is not free. Most settlement companies will charge a percentage of the total debt they are settling for you. In the end, these fees will typically be greatly outweighed by the savings, especially if they can negotiate a significant reduction in your debt, but it's definitely something to account for when weighing your options.  

Always do your research before engaging with a settlement company. And if you're not sure if settlement is right for you, consider working with a nonprofit credit counselor to discuss your options. MMI offers a debt management plan that can help you repay your credit card debts in five years, and often with a significant interest rate reduction to help make your repayment more affordable.