1.5 Debt Settlement Pros and Cons: Overview
1.5 Debt Settlement Pros and Cons: Overview
1.5.1 Debt Settlement Pros
Reduced debt, more favorable payment schedule
Once debt settlement negotiations are complete, collectors can no longer pester you for
the money owed. Perhaps, most importantly, you can no longer be sued over the debt.
“Debt settlement reduces your debt, you pay less than you owe…and it can eventually
improve your credit,” said attorney Leslie Tayne, founder of Tayne Law Group, adding that
“typically you’ll have lower monthly payments as a result of debt settlement, since the
amount owed is reduced. You may also be given a more favorable repayment schedule.”
Improved credit score over the long-term
While it’s true that your credit score may take a hit during the debt settlement process,
over the long run this approach can be beneficial because debt settlement lowers your
outstanding debt and your credit card utilization rate, said Tayne. “Individuals on a debt
settlement program can usually repay their debt in one to four years. Having lower monthly
payments from entering a settlement also allows an individual to get back on their feet and
become financially healthy again.”
Debt consolidation versus debt settlement
Yet another approach to dealing with debt is the debt consolidation process, which
typically involves rolling unsecured debt into one personal loan. Ideally the loan comes
with a lower interest rate than the rate on your credit cards. “Debt consolidation is simply
moving the balance of multiple loans into one loan,” said Tayne.
This approach also has fees associated with it, but it will not damage your credit score the
way debt settlement does.
“Individuals who aren’t struggling with their monthly payments and have good credit are
the best candidates for consolidation,” said Tayne. “Debt consolidation can be a good idea
when the interest rates on the new loan are more favorable than the current loans. It also
allows turning multiple bills each month into just one bill.”
Debt settlement, on the other hand, may be a better choice for those who are struggling to
make ends meet and can’t afford their monthly payments. It may also provide relief from
the stress and anxiety that often comes with significant levels of debt.
1.5.2 Debt Settlement Cons
There are drawbacks and even risks associated with debt settlement, including service
fees, damage to your credit score and, sometimes, an unexpected tax bill.
Fees
The fees associated with debt settlement services vary depending on local state laws.
However, it’s not unusual for a third-party debt settlement professional to charge between
15 percent to 25 percent of the debt being resolved. That means if you’re seeking to settle
a debt of $50,000, you’ll pay a fee based on that amount, not on the final negotiated
repayment amount.
It’s important to note, however, that according to rules enacted by the Federal Trade
Commission (FTC) in 2010, debt negotiation companies may only charge fees after they
have resolved the debt for the client, said Fox, of Freedom Debt Relief.
Damage to your credit score
Going through the settlement process and resolving debt using this approach can
negatively impact your credit score. This, in turn, will make it harder for you to borrow
money at good interest rates or even to get credit at all in the future.
For instance, many debt settlement companies ask that you stop making payments on
your credit card during negotiations because lenders and creditors are not as likely to
negotiate with a consumer who is still able to make monthly payments on their bills. Not
paying bills, of course, damages your credit.
“To settle, most creditors require that an account is in a delinquent status; so, during the
settlement process, an individual’s credit score will often take a hit while the accounts are
in negotiation,” said Tayne. “This means you may also be sued.” In addition, when
accounts are marked as “settled” on credit reports, it can have a negative impact on your
credit score, said Tayne.
Debt settlement is not as quick as you think
Debt settlement is not a quick fix, unfortunately. To begin with, you’ll need to put a
significant amount of money into a settlement account. At the same time, the attorney or
debt settlement company will need to work with each of your creditors to come to a
resolution, and that can take years. It’s not unusual for the entire process to take as long
as three to four years.
Forgiven debt is taxable
While it may be a relief to have your debt settled, and possibly for less than you originally
owed, you may now be on the hook with the IRS. That’s because forgiven debt over $600
is taxable. In other words, you may have to pay taxes on the difference between what you
owe and what you will be paying back.
“The IRS considers forgiven or canceled debt as income,” said Tayne.
You may owe more than when you started
When you begin the debt settlement process, the debt attorney or third-party company will
often advise you to stop making payments on your debt. However, even after you stop
making payments interest will still be accruing on that debt. What’s more, you may also
begin racking up late fees. In the end, these charges may increase your debt to more than
was originally owed.
Other drawbacks:
- In the best-case scenario, 50-70% is the amount by which you might be able to cut your balances by negotiating your debt.
- First, debt settlement generally requires you to come up with a substantial amount of cash at one time. You’ll need to stop and consider where the funds are going to come from and how that money could be used elsewhere in your personal finances, and you want to make sure a large payment now isn’t going to leave you in a tight spot a few months down the road.
- You risk having your credit card account closed completely after the settlement is complete. In other words, your lender may drop you as a client because of your poor track record of paying back what you owe.
- It could encourage imprudent and reckless behavior by historically fiscally irresponsible parties. Some who are relieved of their debt may embark on borrowing sprees in the expectation that their creditors will eventually bail them out.
- Prolonging the payoff of debt due to consolidation, whereby the interest rate is lowered but the term is lengthened.