How Does Debt Settlement Work?

If you’re finding it harder and harder to repay your debt and stabilize your finances, debt settlement could help reduce your burden. Debt settlement, also known as debt relief, is a long-term debt solution that could allow you to regain control of your finances and help you become debt-free. But is it the best solution for your financial situation?

Read on to learn what debt settlement is and how it works, as well as other alternatives to getting out of debt.

What is debt settlement?

Debt settlement is a process by which you —or a party in your name— negotiate with your creditors in order to reduce the overall amount of debt that you owe. This differs from other debt solutions such as a debt management plan (DMP), which structures your payments through a repayment plan offered by a nonprofit credit counseling agency.

By negotiating a lesser sum than what you originally owe, you or an entity negotiating on your behalf can reduce the financial stress in your household. Creditors will often accept a lower payment that’s a sure thing rather than have you default on a loan. The process of debt settlement can be undertaken by the debtor, but it is usually a complicated affair that demands a lot of time and effort.

People who can afford a company to undertake the process on their behalf can enroll in a debt relief program. A debt relief program offers debt settlement solutions run by a debt relief company, which serves as intermediary between you and your creditors when negotiating the terms of the new amount of your total debt.

How does debt settlement work?

Debt settlement programs work by negotiating with your creditors to have you pay a lower amount than what you currently owe. Negotiations vary depending on the total amount owed, the debt relief company and the creditors involved. The percentage of debt that is reduced as a result of debt settlement is usually 30% to 80% of your current outstanding balance.

In most cases, debt relief companies will charge you between 15% and 25% of either the original amount owed or or the new balance your debt relief company negotiates for you. This will also depend on the company you choose to negotiate on your behalf. However, a debt relief company cannot legally charge you any fees before the company has negotiated a settlement with your creditors, you have approved the settlement amount and a payment has been made to the creditor.

Debt relief companies pay your creditors by having you make monthly deposits into a savings account under your control. These funds are then used to eventually pay the reduced balance to your creditors.

The entire debt settlement process can take two to four years to complete from start to finish on average, and it is common that your credit score suffers as you stop making payments to your creditors. After the debt is settled, your credit standing should improve.

What to do before applying for debt settlement

Determine what type of debt you have

Debt settlement solutions are only available for a certain amount and type of debt. To qualify for debt settlement, you usually must owe at least $7,500 in unsecured debt.

Unsecured debt is any debt that is not secured by collateral. This means that most auto and home loans, as well as any loan for which you have used something you own as collateral, do not qualify for debt settlement.

Common types of unsecured debt include credit card debt, medical bill debt and any type of unsecured personal loan. It’s important to have a full picture of your financial situation before contacting a debt relief company or deciding to engage in the debt settlement process yourself. Creditors will need a specific proposal for debt settlement before they agree to your terms.

Consider alternative options

If you are struggling to pay your bills, it is important to know that debt settlement is not the only debt solution that might benefit you. Depending on your financial situation, other options may be more beneficial for helping you get out of debt.

• Debt consolidation: If you’re struggling with unpaid bills because the sheer amount of them is hard to manage, a debt consolidation loan might be a better option for you. With debt consolidation, you can take out a loan to pay off your debts and reduce your multiple payments into a single monthly bill. Depending on your credit standing, this could also help you lower your overall interest payment.
• Home equity loans or a home equity line of credit (HELOC): If you have more home equity than cash and need to pay off some outstanding debt, these types of loans could be of more help than a debt settlement. You access funds through the equity you already own and avoid having to take out a personal loan. These loans do use your home as collateral, so be sure to pay them off in time.
• Balance transfer credit cards: If the amount of debt you owe is mostly credit card debt, you can use balance transfer credit cards to consolidate your debt through a new credit card that offers lower interest rates or 0% APR for a specific amount of time. You can then pay off the card before the trial period expires, saving you from paying exorbitant interest costs.

Choose your debt settlement company wisely

When choosing your debt settlement company, make sure to pick one that has a reliable track record and a strong reputation. Keep in mind that legally, a company cannot charge you fees for a debt settlement before both parties agree to the terms and a payment has been made. If you feel like a debt relief company is promising specifics about your debt settlement deal that sound too good to be true, they probably are.

Choose a company that is accredited by the American Association for Debt Resolution and has great feedback from online reviews. Check impartial sources such as the Better Business Bureau (BBB) or the Consumer FInancial Protection Bureau (CFPB) to ensure that the feedback given to your potential debt settlement company is legitimate.

Final thoughts

Debt settlement, also known as debt relief, is a process that helps you lower your overall unsecured debt by negotiating with creditors to have you pay less than what you owe. Debt relief companies facilitate this process, although you can engage in the process by yourself. Debt relief companies will charge you a fraction of your overall debt, although legally they cannot charge you before you approve a deal with your creditors.