Written by Ben Tejes
Updated Nov 11th, 2022
There are clear pros and cons of debt settlement (debt relief), so it is imperative that you understand the exhaustive list of those differences before deciding whether debt settlement is right for you. Debt settlement is an individual or service that helps individuals achieve debt freedom by negotiating structured and lump-sum settlements directly with creditors. Debt settlement can be a very important way to get out of debt for those who are in the following situations:
1) Have income, but current monthly payments are unaffordable due to a variety of reasons including, but not limited to interest rate increases, minimum monthly payment increases, and promotional APR expiration.
2) Experienced a financial or unexpected hardship such as medical challenges, divorce, unexpected loss of income, or lawsuit.
There are certain pros and cons of debt settlement that you need to be aware of before signing up for a debt settlement program. As such, it’s important to know the exhaustive list of pros and cons to help you make the most informed decision.
This article is quite long, so I wanted to include the video we recently shot covering what you really need to know about debt settlement. We make a lot of content covering debt settlement, so check out our playlist
for a lot of relevant content.
Debt Relief Pros and Cons
The list of Debt Settlement pros and cons below is from perceived highest importance to lowest importance.
1. How Much You Pay Each Month To Debt Could Go Way Down. Savings.
In debt settlement, you can pay less than what is owed. The savings vary per creditor, but the savings can be upwards of 50% or higher. So, if you have $50,000 in unsecured debt, a debt reduction company would try to negotiate that amount down to say $25,000, so you can save quite a bit of money.
Because a debt settlement company can estimate how much you will settle the accounts, for your monthly draft amount could be significantly less than what you're paying now. How much less?
2. Payment Flexibility
Unlike a loan, credit card, or Chapter 13 plan payment
, you have more flexibility each month to set how much your monthly draft is that is sent to the escrow bank account. You can have this flexibility if you are not currently in a settlement.
So, if you'd like to buy Christmas presents for Christmas, some individual may pause the payment for a month to be able to afford presents.
If you pay your credit card minimums, it could take several years to payoff your balances. With debt settlement, once the accounts are settled, you are usually on a fixed payment plan from 12-24 months to 100% resolve your credit.
4. Avoid Bankruptcy
can be a great option for some people, debt settlement allows you to avoid bankruptcy and still get debt relief. For example, if you file a Chapter 7 bankruptcy, your public record will have that mark for 10 years and 7 years for a Chapter bankruptcy. That said you may be able to rebuild your credit after bankruptcy
5. Financial Flexibility
While it may take 4 years to get a convention loan after bankruptcy
, you don't have those restrictions with debt settlement. That said, you would still need to rebuilt your credit after debt settlement, which we will talk about more in the cons section.
Most individuals cancel credit card accounts when entering a debt relief program. This provides accountability not to incur new debt and get on a monthly budget. Some individuals appreciate this aspect of a debt settlement program.
1. Potential for Debt Collection Lawsuit
Some creditors may attempt to sue for the unpaid debt
in a debt collection lawsuit. Each creditor is different. That's why it's important to understand who may sue and who may not sue before entering a debt settlement program or speak to the company about lawsuit likelihood. When we were a debt settlement program, we ran an analysis to help individuals know the lawsuit likelihood by creditor, so we created this free lawsuit likelihood calculator
to help you estimate lawsuit likelihood.
2. Credit Score and Credit Report Impact
Your credit score may be negatively impacted in a debt settlement program. How much will your credit score go down in a debt settlement program. We ran some analysis here
that you can view to understand how that works.
In short, if you are behind on your debt and your credit score has already gone down, you may see a lesser drop than if all your accounts are current. If your accounts are all current, you may also compare debt management to debt settlement
3. Potential Taxes on Forgiven Debt
If you are tax solvent, you may owe taxes on the forgiven debt. If you are tax insolvent, you may not owe taxes on forgiven debt. This is just an estimate, so please speak with a tax advisor to assist.
4. Late Fees and Interest
The debt settlement company often settles the different accounts when they have funds in the escrow bank account. As such, the actual debt at the time of negotiate is often higher, so the negotiated amount will be a higher amount. The increase may be insignificant, but it's important to know about it.
5. Potentially More Expensive than Chapter 7 Bankruptcy
When you look at the cost of Chapter 7 bankruptcy,
you may find that bankruptcy is both faster and cheaper than debt settlement. While this may not be the case with Chapter 13 bankruptcy, Chapter 7 is often the least expensive debt relief option.
6. Creditor May Not Settle Account
While many creditors settle the debt for less than owed, there may be a creditor that will not settle the debt for less than owed. The debt settlement company you work with should understand who settles and who doesn't settle before enrollment, so it's a good question to ask. For example, some credit unions or federal credit unions will not settle debt.
What do you do if you have a creditor who does not settle debt? You may want to keep that account out of the debt settlement program if you choose to continue.
Debt Settlement Alternatives
The two most common alternatives to debt settlement (debt relief) are debt management and bankruptcy. We wrote two articles comparing debt settlement to both options to give you an idea whether one of those options may be better for you:
Debt Management vs Debt Settlement
: Debt management companies work as an intermediary for those in debt and the creditor. The enrollee generally deposits money into an account managed by the debt management company, which is then used to fund the creditors over a specific period of time, generally between 3-5 years. This period is inflexible as the creditor generally sets a maximum time limit for the debt to be resolved.
Debt Settlement vs. Bankruptcy:
There are two main types of bankruptcy - Chapter 7 and Chapter 13. The main difference between Chapter 7 and Chapter 13 bankruptcies is that all your debt is wiped out in Chapter 7 regardless of what you owe, whereas Chapter 13 is a restructuring of your debt, which is somewhat similar to Debt Settlement.
How Debt Settlement Works
Debt settlement companies similarly work as an intermediary for those in debt and the creditor. The debt settlement company will do the following for the enrolled participant:
1. Create an enrollee-owned escrow bank account for the enrollee to consolidate all of the payments into one payment for the creditors.
2. Communicate to the creditors that they are the primary point of contact going forward to prevent future debt-collection calls to the enrollee.
3. Negotiate on behalf of the enrollee with each of the creditors for the lowest possible rate based on financial hardship.
4. Get consent from the enrollee on whether to accept the settlement and payment plan.
5. Manage all of the payments to the creditors until the debt has been completely resolved.
Is Debt Relief Legitimate?
There is a plethora of debt settlement companies to choose from. Although most of them provide a free consultation, promise you to reduce what you owe, and promise you to be debt free faster, there are many points to consider:
Know the Fees
I cannot stress this enough. Debt settlement companies have been known to improperly disclose fees. Therefore, it's imperative to know all the fees before you sign. You can save a lot of money and get out of debt, but high program fees can really eat away from your savings.
- Does the company charge program fees BEFORE you reach a settlement? This is frowned upon by the industry, and we believe that it is right to frown as many of these company fail to properly settle the accounts for you.
- Does the company front load fees AFTER you reach a settlement? This is where a debt settlement company charges a lot up front instead of spreading the fees over multiple payments.
- Many debt settlement companies charge a percentage of enrolled debt and a banking fee. You should know what percentage they charge and what the banking fee is. For example, having to pay 25% on an enrolled debt amount of $30,000 vs. 15% on an enrolled debt means that you would have to pay an additional $3,000. It's a big deal.
It's imperative to understand who you will be working with AFTER you join the program. Many debt settlement companies have a salesman make the sale and then transfer you to a customer service specialist once you join the program. It may be helpful to find a program where you work with the same person from start to finish.
There are many review sites that will charge a fee to debt settlement companies for them to have a glowing review of the service, meaning that there is inherent bias because the advertiser is only giving a positive review because of the amount that the debt settlement service is paying.
Not all debt settlement companies are created equal when it comes to data utilization to maximize debt reduction. This can be a question you ask in the onboarding process, "How does your debt settlement company use its data to maximize my debt reduction?" If the salesman does not know the answer or tries to make up an answer, the company probably does not use its data.
Is Debt Settlement Best For Me?
Debt settlement can be an excellent way to get out of debt and achieve financial freedom. Whether it's best for you depends on each individual as everyone comes to the table with different experiences and goals. Generally, we can help you understand your options by a combination of your goals and preferences, mathematical equations of your income and expenses, and a full understanding of what will save you the most money and allow you to best achieve debt freedom.
Complete a short questionnaire to help you understand the cost and duration and alternatives to debt settlement.