Relieving debt stress: How does debt settlement work?

If you’re wondering how does debt settlement work, rest assured that you’re not alone. Amid rising inflation and the growing costs of everyday living, it’s all too easy to find expenses mounting and savings dwindling as of late, prompting many to turn to credit cards, personal loans and other measures.

All can be helpful tools when used in moderation, especially as you think about how to balance your monthly budget, build a credit history, and get the most from every dollar. But if you should find yourself getting behind on payments, it helps to know what debt settlement is and how it works. Put simply, it’s an option that allows you to work with creditors to reduce the amount of debt that you owe in order to improve your overall financial health.

Feeling concerned about money? Debt negotiation discussions with lenders can help you relieve debt stress and keep financial headaches to a minimum. Let’s take a closer look at how debt settlement works, what’s involved in the process, and how to determine if this debt relief strategy is right for you.

Key takeaways:

• Debt settlement allows you to reduce balances owed to creditors
• Agreements made can help alleviate stress and worry
• It’s up to individual creditors as to whether to settle on debts, however
• Several alternative arrangements and financial products can also help
• There are pros and cons to any such arrangement

What is debt settlement?

Debt settlement is a type of negotiation agreement that you make with a creditor. As a financial strategy, it focuses on helping you settle an outstanding debt for a lower amount than you actually owe on the current balance. In practical terms, your creditor effectively forgives part of the debt that you owe and agrees to accept the smaller compensation (repayment) amount. Such agreements provide a way for creditors to maximize the odds that they’ll see repayment from borrowers who may otherwise be struggling to make payments.

Debt settlement typically requires you to pay the negotiated amount in one lump sum so as to minimize any potential financial risk to the lender. Agreements must be negotiated and entered into with each individual creditor, however. This means that the amount of money from your outstanding balance that will be forgiven and that you no longer owe will vary depending on the creditor and your specific financial situation. Of course, not all creditors will be open to a settlement plan, but taking the time out to be proactive and open discussions is recommended if the current debt has become financially unmanageable. That’s because doing so is generally perceived as an act of good faith by creditors, who’ll typically want to work with you to help you successfully manage your debt balances.

Debt settlement should not be confused with a debt consolidation loan, however. The latter type of debt-reduction strategy describes a scenario under which all of your outstanding debt is combined into one loan to make repayment more manageable. The main difference between debt settlement and debt consolidation is that when you turn to debt consolidation, your debt won’t be forgiven, as it can be under a debt settlement agreement.

Settlement of debt example

By way of illustration, let’s say you currently are carrying $20,000 in credit card debt. Because you’re struggling with making the monthly payments, you decide to discuss debt settlement with your creditor. Based on negotiations, the financial institution who issued the card decides to accept a $12,500 payment from you and forgive the other $7,500 balance that is owed. That $7,500 is no longer your responsibility to pay and will be erased from your account.

What type of debt is eligible for debt settlement?

Armed with an understanding of what debt settlement is and how it works, you might wonder about what types of debt are eligible for debt settlement. The short answer: unsecured debt – that is, any debt that doesn’t involve giving up some form of collateral in exchange for access to funds, is potentially negotiable. Let’s take a closer look at it, and how secured debt differs in practice.

Secured debt

Secured debt is backed by collateral such as a borrower’s car or home. Should a borrower default on it, a lender can repossess items to help offset outstanding balances owed.

Examples of secured debt include:

• Mortgages: Backed by your home, which is used as collateral. Should you default on balances and fail to make payments, a financial lender will have the option of foreclosing on the property.
• Car loans: Your vehicle functions as collateral, and a lender can repossess your car if balances are defaulted upon.
• Home equity loans: Such financial products rely on equity that you’ve built up in a property as collateral. Should you happen to default, lenders will have the option of foreclosing on the house. 

Unsecured debt

Unsecured debt is not backed by items of collateral. This means that you won’t have to put your vehicle or real estate property at potential risk to access it. Instead, financial lenders choose whether to extend it or not based on factors like your credit score, credit history, DTI ratio, and other determinants.

Examples of unsecured debt include:

• Credit card debt: One of the most common debts forgiven with debt settlement is credit card debt. Since credit card debt is unsecured, it’s eligible for debt settlement.
• Medical bills: Any unpaid medical bills are also considered unsecured and could be eligible for debt settlement.
• Unsecured personal loans: Any debt you have through unsecured personal loans could be eligible for debt settlement.

Medical bills

Should you fall behind on paying medical bills in particular, note that debt settlement isn’t the only option available to you. For example, many medical systems and hospitals offer patients financial assistance based on income and individual ability to pay outstanding balances. Such programs allow select individuals who qualify for them to pay a fraction of their overall hospital debt, which can help you cut back on medical expenses.

Are student loans and taxes eligible for debt settlement?

As you look at crunching the numbers, it’s also important to understand what type of outstanding debts that the process of debt settlement can’t forgive. Such forms of debt may be secured by your property, which effectively provides a way for you to compensate a lender in the event of non-payment. Alternately, others including but not limited to child support, taxes and alimony are not dischargeable under a bankruptcy scenario as the law allows creditors legal means to recover these debts.

It may help to note that as a general rule of thumb, if your debt is attached to a physical item (house, car, etc.) or piece of collateral that could be foreclosed upon or repossessed, it’s not eligible for debt settlement. See examples below.

• Mortgage loans: Because home mortgage loans are tied to a physical property that a lender could foreclose upon, homeowners should be aware that they are not eligible for debt settlement.
• Auto loans: In addition, auto loans are not eligible for debt settlement, as these loans are backed by collateral in the form of your car.

But on top of it, there are two forms of unsecured debt that are also typically ineligible for debt settlement: student loans and taxes.

• Student loans: Private student loans are usually not eligible for debt settlement. However, government-sponsored federal student loans may be, provided that meet certain Department of Education guidelines (for example, you are able to pay a portion of the outstanding balance) and have missed payments for a minimum of 270 days. Also note that income-based student loan repayment plans may assist you in your efforts to remain financially compliant.
• Tax debt: If you have any tax debt from not paying the balance you owe, this type of debt isn’t eligible to be forgiven with debt settlement. But the Internal Revenue Services (IRS) frequently does offer installment-based payment plans for those who need more manageable payment terms.

The pros and cons of debt settlement

Arranging a debt settlement agreement with a creditor can prove helpful, enabling you to decrease debt-related stress and eliminate the financial burden that’s associated with high-interest or large debts. At the same time, there are several downsides associated with going this strategic route that you’ll want to consider as well. As you weigh your options, it’s important to review both the pros and cons of debt settlement before you commit to entering into any such agreements with your creditors.

Pros

• A portion of your outstanding debt balance could be forgiven. The most significant advantage to debt settlement is the possibility of decreasing the total amount of money that you owe to your creditors.
• Working out a debt settlement agreement also allows you to better budget for your current financial circumstances and/or improve your financial health over time.
• Debt settlement can further help you alleviate stress and worries due to extensive financial burdens.
• As part of the process, you’ll work directly with each creditor. That allows you to discuss a variety of potential settlement scenarios and find a middle ground that is financially feasible.
• The practice creates a pathway to help you become financial solvent again over time.

Cons

• Debt settlement agreements can remain on your credit history and negatively impact your credit score for as long as 10 years. You’ll want to research possible debt relief options before going this route.
  • Settlement companies can be costly to employ. If you choose a debt settlement company to help you work through a settlement plan with lenders and creditors, you’ll have to pay the company a sizable percentage of the amount settled upon. Also, settlement companies often want you to stop making payments while they work through your plan. This can lead you to fall behind on payments, negatively impacting your credit score.
• If you choose to work with a debt settlement company, it’s extremely important to do your homework. While some firms are legit, others are less scrupulous. Noting this, it’s important to research the company via the Better Business Bureau and online review sites. Keep in mind that negotiating with creditors yourself independently is also a viable option.
• To avoid legal hiccups, it’s important to get everything in writing, both from your creditors and any settlement company with which you may elect to partner.
  • You might owe more money in taxes. The IRS counts settled debt as a form of income. Therefore, you might have to pay income taxes on the settled amount. Before you choose to settle your debt, you must understand the possible tax ramifications.
  • Creditors might not forgive your debt. The option to engage in debt settlement is entirely up to creditors, and certain forms of debt may not be eligible for such agreements, especially debts that are secured by physical property that can be repossessed or foreclosed on.

5 Alternatives to debt settlement

As you weigh your financial options, keep in mind that debt settlement isn’t the only way to tackle mounting balances. When considering which pathway forward is best option for you, you’ll also want to consider the following alternative options to relieve debt stress.

1. Debt consolidation

The practice of debt consolidation combines your outstanding balances into a single lump-sum loan (usually a personal loan). You will make a monthly payment on this loan; the advantage being that such loans, which are easier to manage, typically offer a lower interest rate (especially when compared to credit cards). That makes it easier to pay down the debt and provides financial breathing room.

Be advised though that consolidation loans do not allow your debt to be forgiven, and paying off your debt in full can take time. However, making monthly payments on time each month can help provide much-needed financial relief, and also help you improve your credit score.

2. Bankruptcy

While this debt-reduction option can seem scary or overwhelming, keep in mind it’s a common step that many borrowers take – and one may be necessary to move past a challenging financial situation.

Chapter 7 bankruptcy helps get rid of most unsecured debts while Chapter 13 bankruptcy enables you to create a repayment plan to start paying secured debts while getting rid of unsecured debts.

The major downside of bankruptcy is the impact that it can have upon your credit score. A Chapter 13 bankruptcy or Chapter 7 bankruptcy can remain on your credit report for up to 7 or 10 years, respectively, and reduce your overall creditworthiness as well as lenders’ willingness to extend financing.

Note that not all debts may be dischargeable via bankruptcy, however. For instance, tax debts and select forms of student loan debt (such as private loans) may not be discharged as discussed prior.

If you’re concerned about your living situation during the process, it also helps to be aware of bankruptcy exemptions. These are forms of legal protection that allow borrowers to keep and maintain the use of select assets such as their home and car during the bankruptcy filing process. Bankruptcy exemptions provide a means through which to retain access to basic living and employment necessities, even after you’ve filed.

That said, a home with equity beyond the allowed bankruptcy exemptions can be repossessed and sold to repay debts. In any event, if you’re considering filing, it’s important to discuss bankruptcy options with a qualified legal professional. But rest assured that filing for bankruptcy will still leave you with options for getting back on your feet in the end.

3. Credit card balance transfers

A balance transfer happens when you take a preexisting credit card balance and transfer it over to a new credit card, which typically offers more advantageous financing terms. For example, a significant advantage of many balance transfers is that your new credit card may have a 0% APR for a set number of months (usually the first year of opening the card). Incurring zero interest charges for a time (thereby temporarily lowering monthly fees) on your monthly credit card payments could help you pay down some major debt. When you transfer the balance of a high-interest credit card to a lower-interest option, however, you’ll want to discontinue use of the higher-interest card (otherwise, you risk entering a debt cycle).

4. Home equity loans or HELOCs

Also, if you’re a homeowner, you’ll enjoy the option to take advantage of the equity that you have built up to date in your home. That’s because home equity loans allow you to use your house as collateral to borrow money. A variety of options – like a Home Equity Loan from Rocket Mortgage® – enable you to consolidate your debts into one loan and make a single, easier to manage monthly payment on it … potentially with a lower interest rate.

Similarly, with a HELOC (home equity line of credit), you can also borrow against your home equity. HELOCs, however, are structured as a line of credit that you pay back. With a HELOC, you get to only use the spare funds that you need.

5. Debt management plans

Debt management plans are strategic plans put in place by the indebted borrower and a debt management company or nonprofit credit counseling agency. You’ll work together with the company or agency to develop a debt management plan that works best for your financial situation. From there, you’ll create a monthly payment plan where you pay the debt management company, and they’ll pay your creditors. Remember that this can take time, depending on the amount of debt you owe.

Under any circumstances, as above, it’s important to conduct due diligence and extensively research any debt consolidation companies that you’re considering partnering with. While many reputable companies exist that can help borrowers, instances of scams and fraud are also common.

FAQ: Debt settlement

Borrowers generally have several frequently asked questions (FAQs) about debt settlement. Answers to the most common queries can be found below.

Is debt settlement a good idea?

 Yes and no. It can help you become financially solvent again if you’re facing overwhelming debts, and help you avoid having to declare bankruptcy. But pursuing debt settlement isn’t guaranteed to be successful, as agreements must be negotiated with each creditor, and it can have a lasting impact on your credit score. If you work with a debt settlement company, you may pay fees of 15% – 25% of the amount you owe creditors as well.

How do you negotiate credit card debt settlement yourself?

 After gathering details on your credit cards, APR and outstanding balances, and determining how much you can afford in payments, you’ll want to contact your creditor. Upon calling or writing, you’ll explain your scenario, propose a settlement offer, and negotiate with the financial institution. Once a consensus is reached, you’ll need to finalize an agreement in writing as well.

Does debt settlement hurt your credit?

 In short, yes. Debt settlement can lower your credit score by as much as 100 points or more. The negative impact of a debt settlement procedure can last for up to 7-10 years as well. The extent of the drop tends to be determined by variables such as your preexisting credit history and amount of debt settled.

How long does debt settlement stay on your credit report?

 It can remain on your credit report for up to 7 – 10 years following the date upon which your first missed payment occurred. In other words, the clock starts ticking once the debt first becomes classified as delinquent.

Can I still use my credit card after debt settlement?

Yes, it’s possible to do so, provided that you have kept the account active and open. But you’ll want to be careful to do so in responsible fashion and not accumulate more unpaid debt, especially in large amounts.

The bottom line: Debt settlement helps alleviate financial stress

Even if you’ve accrued significant debt to date, remember that it doesn’t have to weigh you down forever. If you’re experiencing a period of temporary or sustained financial hardship, it helps to know that there are solutions for managing debt that can help you get your finances back on track. Debt settlement solutions could present a smart option for those looking to eliminate a portion of their eligible debt.

That said, given potential impacts on your credit, you’ll also want to research potential options for financial relief before seeking to reach a debt settlement agreement with creditors. After all, alternatives such as debt consolidation loans, balance transfers, home equity loans, bankruptcy, and debt management plans are also available to those looking for a different way to reduce or better manage their debt load.

Interested in exploring options to improve your financial health? A great first step is to reach out to  prequalify for a personal loan to help consolidate your debt today.