Debt settlement is a practice that allows you to pay a lump sum that’s typically less than the amount you owe to resolve, or “settle,” your debt. It’s a service that’s typically offered by third-party companies that claim to reduce your debt by negotiating a settlement with your creditor. Paying off a debt for less than you owe may sound great at first, but debt settlement can be risky, potentially impacting your credit scores or even costing you more money.

Are you struggling to pay off a high amount of debt? If so, it may be tempting to turn to a debt settlement company in hopes of reducing the amount you owe. Debt settlement is a service offered by third-party companies that can try to reduce your debt by negotiating settlements with your creditors or debt collectors. Some debt settlement companies may be successful at reducing your debt, but their services and programs also come with risks that could leave you deeper in debt. Debt settlement could even end up damaging your credit.

Here’s some key information you should know about how debt settlement works, its pros and cons, and how it could affect your credit.

How debt settlement works Debt settlement companies may also be known as “debt relief” or “debt adjusting” companies. The companies generally offer to contact your creditors on your behalf, so they can negotiate a better payment plan or settle or reduce your debt. They typically charge a fee, often a percentage of the amount you’d save on the settled debt.

The company may try to negotiate with your creditor for a lump-sum payment that’s less than the amount that you owe. While they’re negotiating, they may require you to make regular deposits into an account that’s under your control but is administered by an independent third-party. You use this account to save money toward that lump payment.

While they negotiate, the debt settlement company may also advise you to stop paying your creditors until a debt settlement agreement is reached.

Once the debt settlement company and your creditors reach an agreement — at a minimum, changing the terms of at least one of your debts — you must agree to the agreement and make at least one payment to the creditor or debt collector for the settled amount. And then the debt settlement company can begin charging you fees for its services.

Tayne considers a successful settlement to be one that “allows a client to walk away without having to pay their full debt amount.”

Keep in mind that there is no guarantee the company will be able to reach a debt settlement agreement for all of your debts.

Debt settlement pros and cons There can be a few pros to debt settlement, but you should carefully consider the potential risks of debt settlement as well.

The pros Settling a debt through a debt settlement company could …

Lower your debt amount Help you avoid bankruptcy Get creditors and collectors off your back The cons But the risks may outweigh the benefits.

  1. Your creditors may not agree to negotiate Not only is there no guarantee that the debt settlement company will be able to successfully reach a settlement for all your debts, some creditors won’t negotiate with debt settlement companies at all.
  2. You could end up with more debt If you stop making payments on a debt, you can end up paying late fees or interest. You could even face collection efforts or a lawsuit filed by a creditor or debt collector. Also, if the company negotiates a successful debt settlement, the portion of your debt that’s forgiven could be considered taxable income on your federal income taxes — which means you may have to pay taxes on it.
  3. You may be charged fees, even if your whole debt wasn’t settled Debt settlement companies can’t collect a fee until they’ve reached a settlement agreement, you’ve agreed to the settlement, and you’ve made at least one payment to the creditor or debt collector as a result of the agreement. But you could still end up paying a portion of the debt settlement company’s full fees on the rest of your unsettled debts, says Bruce McClary, vice president of public relations and communications at the National Federation for Credit Counseling.

“If you have five or six creditors and the company settles one of those debts, they can start charging a fee as soon as they receive a result,”

And if a debt relief company settled a “proportion” of your total debt enrolled with its program, it can charge you that same proportion of its total fee. For example, if your total debts came to $10,000, and a debt relief company settled $5,000 of the total amount, it’s allowed to charge 50% of the total agreed-upon fee.

  1. It could negatively impact your credit A debt settlement company may encourage you to stop making payments on your debts while you save up money for a lump-sum payment. But at this point, your creditors might not have agreed to anything, which means all those payments you’re missing can wind up as delinquent accounts on your credit reports.

Your credit scores could take a hit as a result of any delinquent payments, and the creditor could also send your account to collections or sue you over the debt.

Alternatives to debt settlement

Negotiate your own settlement Try negotiating settlements with creditors on your own. Offer an amount that you can pay immediately, even if it’s less than what you owe.

Transfer balances If you have credit card debt, consider a balance transfer. A balance transfer is when you move debt from one credit card to another, usually to take advantage of an introductory 0% interest offer on the new card.

Balance transfer cards typically have one of these 0% intro APR offers for a specified period of time and may charge a fixed fee or a percentage of the amount you transfer.

To figure out if a balance transfer is a good idea for you, check whether you’ll pay more money on the interest payments on your current card than the cost of any balance transfer fees. And you should also try to pay the balance off before the card’s promotional period expires to avoid paying interest on your balance

Seek nonprofit credit counseling Nonprofit organizations may provide credit counseling services that offer free or low-cost advice on budgeting and debt management. Credit counseling organizations don’t typically negotiate to reduce debt. But they may work with creditors on payment plans or to stop late fees or collection efforts.

Bottom line Debt settlement companies may be able to reduce your debt amount with creditors, but there are no guarantees.

Before you enroll in any debt settlement program, the Consumer Financial Protection Bureau recommends contacting your state attorney general and local consumer protection agency to check whether there are any complaints on file. The state attorney general’s office can also check if the company is required to be licensed and whether it meets your state’s requirements.

Ultimately, you may find that it’s a better bet to work on your own or with a nonprofit credit counseling organization instead.

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