How does debt settlement work?

Having a lot of debt can take a significant toll on your financial, mental, and even physical health. Of course, it places a financial burden, making it more challenging to save for other goals like retirement or buying a home. And the added stress can take a toll all its own.

If you’re struggling to pay off your debt, debt settlement may be an option worth considering. It allows you to negotiate with your creditors to relieve some of your financial burden and the stress that comes with it.

Of course, there are also some downsides to debt settlement, so keep reading to learn how it works and whether it’s the right choice for you.

What is debt settlement?

Debt settlement is the process of negotiating with your creditors to settle your debt for less than you actually owe. Creditors are often willing to accept a lower payment, either as a lump sum or installment payments, in exchange for the assurance they’ll get paid.

Debt settlement can help reduce your principal debt amount, but can also help you address costly fees and interest.

Debt settlement isn’t recommended — or even available — for every type of debt or every situation. It requires the cooperation of both the creditor and you as the borrower. However, if your debt has become overwhelming and you may otherwise not be able to repay it, it’s an option worth considering.

Settlement of debt example

Suppose you have $15,000 of credit card debt to pay off, but due to the high interest rates and a change in your financial situation, you’re unable to pay it back.

Your credit card company wants to ensure they recover at least a portion of their money, so they agree to debt settlement. Rather than requiring you to pay back the entire $15,000, the creditor accepts a $10,000 payment and forgives the remaining $5,000.

The settlement benefits both parties: the creditor gets paid at least some of what they’re owed, while you eliminate a portion of your debt, allowing you to become debt-free.

What type of debt is eligible for debt settlement?

Generally speaking, debt settlement is only available for unsecured debt, meaning debt that doesn’t have any collateral attached to it. Some of the most common types of debts you might use debt settlement for are credit cards and personal loans.

Credit card debt is one of the most commonly forgiven types of debt. Because of the high interest rates and compounding interest, it’s easy for consumers to rack up large amounts of credit card debt, but often difficult for them to pay it off. And because creditors have less recourse than they might have for other loans, they may be more willing to negotiate a settlement.

Similar to credit cards, personal loans are another frequent target of debt settlement. These loans are usually unsecured. And though they have lower interest rates than credit cards, they can still become problematic for borrowers who struggle to pay them back.

Unsecured vs. secured debt

As we mentioned, debt settlement is typically available for unsecured loans. Secured loans, including mortgages and auto loans, likely aren’t eligible.

The reason you can’t usually use debt settlement for secured loans is that these loans have collateral attached to them. Per your loan agreement, the lender is able to seize that collateral to recover its losses.

For example, if you stop making your mortgage payments, your lender can foreclose on your home and sell it to pay off the loan. There’s little incentive for the lender to settle the debt for less than the total balance. The same applies to other secured loans like auto loans.

Debt settlement options for medical bills

Medical bills are another type of unsecured debt that can easily become overwhelming. And while it can be eligible for debt settlement, that’s not always the best option.

Medical debt is often eligible for other programs that can help you repay it. For example, many hospitals and medical centers offer financial assistance based on income. If your income falls below a certain threshold, the hospital may discount your bills. Additionally, even if you don’t have a low income, you may be eligible for interest-free payment plans, cash-pay discounts and other types of assistance that can reduce your debt burden.

If you’re struggling to pay off your medical debt, it’s important to explore these other options before automatically jumping to debt settlement.

Are student loans and taxes eligible for debt settlement?

Two notable types of unsecured debt, federal student loans and tax debt, aren’t usually eligible for debt settlement, at least not in the same way as credit cards and personal loans would be. An important distinction with federal loans and federal tax debt is that in both cases, your lender is the federal government rather than a private lender.

If you’re struggling with your student loans or tax debt, first know that you may be eligible for other types of payment relief.

For example, the IRS offers payment plans to taxpayers who owe less than $50,000 in taxes, penalties, and interest and who are up to date on their tax returns. Similarly, the Department of Education offers various types of relief, including income-driven repayment plans, deferment and forbearance.

In extreme situations, you can lower your debt burden. The IRS and the Department of Education both offer processes where you can compromise on your debt, which is essentially the same as debt settlement. However, you’ll be required to meet specific eligibility requirements, including demonstrating financial hardship or an inability to repay your debt.

Finally, it’s important to note that the information above only applies to federal student loans. Private student loans, because they are offered by private lenders, may be eligible for debt settlement in the same way that credit cards and personal loans are.

The pros and cons of debt settlement

Debt settlement comes with some key benefits, including allowing you to reduce your debt burden and focus on other financial goals. However, it also has several downsides, from the cost to the potential negative outcomes. It’s important to weigh these pros and cons before proceeding.

Pros

• Reduced debt burden: If your debt settlement is successful, you can have a portion of your debt forgiven, allowing you to shift your focus to other financial priorities.
• Help from a professional: When you work with a debt settlement company, you don’t have the stress of dealing with your creditors alone. You also may be more likely to get a successful settlement.
• End debt collection efforts: If your creditor has been calling you about your debt, negotiating a settlement could help end those intrusive debt collection efforts.
• Avoid bankruptcy or lawsuits: Debt settlement can help you avoid more serious consequences for your debt, including bankruptcy or a lawsuit from your lender.

Cons

• Could hurt your credit score: Debt settlement often requires stopping payments on your debt during the negotiations, which will harm your credit score, even if the debt settlement is successful.
• Requires fees: Working with a debt settlement company isn’t free — you could be on the hook for costly fees, which eliminates some of the benefit of settling in the first place.
• Possible tax consequences: Your forgiven debt is considered income in the eyes of the IRS. As a result, you’ll have to pay income taxes on that portion.
• No guarantee of success: Debt settlement isn’t always successful. Your creditor could simply refuse to negotiate. Then, you’ll have some of the downsides of debt settlement, such as a lower credit score, without the benefits.
• Risk of scams: There are plenty of scams in the debt settlement industry, so you have to tread carefully to ensure you find a reputable company.

5 alternatives to debt settlement

Debt settlement has some clear benefits, especially in certain situations. However, if you’re uncomfortable with debt settlement or it isn’t suitable for your debt situation, there are some alternatives you may consider.

1. Debt consolidation

Debt consolidation is the process of combining multiple debts into one, usually through a personal loan. You take out a new personal loan and use it to pay off your existing debts (usually credit cards and other personal loans).

Debt consolidation has several benefits, including simplified monthly payments, and possibly a lower interest rate and monthly payment. While your debt isn’t reduced like it is with debt settlement, it may be easier to pay off.

2. Bankruptcy

Bankruptcy is usually a last resort in managing your debt, but it may be worth considering if you’ve exhausted all of your other options.

There are two primary types of bankruptcy. Chapter 7 bankruptcy liquidates most of your assets and, in exchange, discharges most of your debts. Chapter 13 bankruptcy, also known as a wage earner’s plan, helps you create a payment plan for your debt, and may ultimately result in some of your debt being forgiven.

It’s important to note that not all debts can be discharged in bankruptcy. For example, court-ordered debts like alimony and child support, tax debt, and federal student loans generally can’t be discharged.

Another downside to consider is that Chapter 7 bankruptcy stays on your credit for 10 years while Chapter 13 stays on for 7 years. During that time, you may find it challenging to access new credit.

3. Credit card balance transfers

A balance transfer can be an excellent way to help you address your credit card debt without the cost or negative credit impact of some alternatives.

A balance transfer is just what it sounds like — you transfer the balance of your credit card to a new card, ideally one with a 0% annual percentage rate (APR) for a certain amount of time (often ranging from 6 to 18 months). If you can repay your debt within the interest-free period, you won’t pay any interest on your debt at all. Additionally, you may see a positive impact on your credit score.

One downside to consider is that balance transfers usually require a fee of 3% to 5% of your balance, which eats into some of your savings. Another downside is that you usually need good credit to qualify for a decent balance transfer offer.

4. Home equity loans or HELOCs

Home equity loans and HELOCs (short for home equity line of credit) both allow you to tap into your home equity for cash. Like your mortgage, these lending tools use your home as collateral, allowing you to borrow at a lower interest rate.

And like personal loans and credit cards, home equity tools can be used for nearly any purpose, making them a popular option for debt consolidation.

A home equity loan is a type of installment loan, similar to a personal loan. A HELOC, on the other hand, functions like a credit card, where you can borrow and repay your balance again and again, only repaying what you actually borrow. Our sister company, Rocket Mortgage®, offers a Home Equity Loan. Speak with one of our Home Loan Experts to see if this option is right for you.

5. Debt management plans

A debt management plan (DMP) is another tool to manage your debt without the negative impacts of debt settlement.

A DMP, usually done through a credit counselor, allows you to create a payment plan for your debt. Your credit counselor works directly with your creditors to set up the payment plan. You’ll send your payment each month to your credit counselor, and they’ll distribute the funds to your creditors. The counselor may also be able to negotiate a lower balance, interest rate, or fees.

Unlike debt settlement, DMPs are often done through non-profit credit counseling organizations, making them more reputable and trustworthy than some debt settlement companies. Additionally, because you continue to make your monthly payments, you don’t have to worry about your credit taking a hit.

Just like when you’re considering debt settlement, make sure you research and vet various credit counseling organizations to choose the right option for you.

The bottom line: You can get out of debt successfully

While it may not feel like it today, your debt doesn’t have to weigh you down forever. It’s possible to get out of even the most overwhelming debt situation by using the tools and strategies at your disposal. Debt settlement is a popular option because it can reduce your debt burden significantly, especially for high-interest debt like credit cards and personal loans.

That being said, debt settlement isn’t right for every person or situation. It’s important to consider your alternatives, including debt consolidation, balance transfers, home equity lending, debt management plans, and bankruptcy.