Debt settlement is often portrayed by settlement companies as a magic bullet for anyone drowning in debt. But the truth is, debt settlement is only an ideal debt solution if :
- You have $10,000 or more unsecured debt
- You’re frequently late on debt payments
- You’re having trouble making the minimum payment amounts every month
- You cannot afford your debts and are considering bankruptcy
There is a difference between debt management and debt settlement, so make sure you know which one is right for you.
How Does Debt Settlement Work?
If you decide to use debt settlement to handle your debts, you or a third-party company will reach out to your creditors to negotiate a new repayment plan. This new payment plan will be based around a smaller total amount than your original debt. In exchange for paying less, you instead agree to make a single, lump-sum payment to pay the debt off completely. Once the agreed-upon amount is fully paid, your account is marked “settled” on your credit report. This process usually takes 2 to 4 years and can help you avoid bankruptcy.
Is Debt Settlement Bad For Your Credit?
Debt settlement can have both a positive and negative effect on your credit. For some strategies, your credit score may get worse before it gets better.
Many debt settlement companies advise you to skip your payments in order to save up to pay one large sum. However, there is no guarantee that your creditors will agree to this payment method, and they may begin to report your delinquent payments to the major credit bureaus. This results in a negative effect on your credit history and a lower credit score.
As you pay off the debt, your credit report will begin to show active, on-time payments over time. This shows that you are responsibly using your credit and will reflect positively on your credit score.
Furthermore, using debt settlement is one of the main ways to avoid filing for bankruptcy. While debt settlement notations stay on your credit report for seven years, bankruptcy notations stay on for 10 years. Bankruptcy has a longer-lasting effect on your life regardless of the changes you make.
Alternatives to Debt Settlement
According to a study by the American Fair Credit Council, 95% of debt settlement clients receive savings in excess of fees, with an average save of $2.64 for every $1 in fees paid. With statistics like these, you might believe that reaching out to a debt settlement company will help you get rid of debt and fix your credit once in for all.
However, debt settlement does not work for everyone. Every financial situation is unique and may require a specific way to handle your debt issues. There are several debt solution alternatives to look into before you decide on the best course of action:
Debt Management Plans
A debt management plan (DMP) is a program aimed towards helping you pay off your debt fast. Entering a DMP will give you access to a qualified coach who will help you:
- Create a budget
- Create a financial plan that fits your needs
- Track your progress
- Work with creditors on creating better payment plans
- Stop collection calls
Unlike debt consolidation, you do not need good credit to qualify for a DMP. While this program does not have any direct effect on your credit, the actions you take while in the program may have a temporary negative affect. However, if you stay on the plan and make on-time payments, your credit history will improve over time.
Debt Consolidation
Debt consolidation is the act of taking out a loan to pay off multiple debts at once. This would eliminate the need to pay multiple monthly payments and instead only require you to pay one.
Ideally, this new loan would have a reduced interest rate and will help you pay off your debts quickly and efficiently.
However, not everyone is qualified for debt consolidation. You need to have a high credit score and a good debt-to-income ratio. If you’re already experiencing financial difficulties, you may not qualify for a debt consolidation loan.
Balance Transfers
A balance transfer is the process of paying off one credit card debt with a new credit card. There are several benefits to moving your debt from one card to another, including:
- Consolidating multiple payments into one payment
- Potentially receiving a lower interest rate
- Earning rewards points on a new card for repayment
However, you should be careful before you apply for a second or third card. New cards typically come with 3-5% balance transfer fees. These fees are added to any other fees you may be required to pay, including signup fees or APRs.
And while signing up for a new card may give you a better interest rate, it may only be an introductory rate. When the introductory period expires, your interest can shoot up to be much higher than the rate you paid before. This encourages you to completely pay off your transferred credit card balance before the promotional period ends.
Finally, there is the danger of falling into the moving-debt-around habit. Every time you transfer debt from one card to the next, the debt does not go away. In time, you may find that you’ve paid more in fees and added interest than the original amount owed. This path can quickly move you towards bankruptcy.
DIY Debt Negotiation
If you feel confident, you can also tackle debt negotiation by yourself. This could help you avoid having to spend any more money on third-party fees.
However, your lending company is under no obligation to provide any alterations of your loan terms. Negotiating for an alternative payment plan or lower fees may not work.
Before you talk with your creditor directly, take a look at all of your debts. Organize them by size, length, and repercussions for not paying. This will allow you to decide which debts to negotiate for first.
When you reach out to your creditors, provide alternative pay-off terms that you wish to use. This may include paying a smaller amount every month, a lump-sum settlement amount, or a settlement in installments. You can also request an end to collection calls and letters.
Remember to document every step of your process, and bring any sort of documented proof of income with you. The Consumer Financial Protection Bureau ‘CFPB’ of the U.S. Government advises that you record your conversation with the debt company (with their consent) so you have proof of the agreement.
Rebudgeting
Some people have enough money to pay the bills but struggle with handling it correctly. Luckily, the best way to determine if you actually can afford your debts is to sit down and create a budget.
To set up a budget, start by tallying up how many monthly bills you have and subtracting it from your monthly income. Keeping these bills and due dates written down will help you keep track of what you need to pay and when. It will also help you determine how much money you have leftover each month to do whatever you would like with.
Need some help setting up a budget? Take our free budgeting class. This course includes the basics of budgeting, tracking your spending and establishing goals.
Credit Coaching
Whether it’s a job layoff or a medical emergency, maxing out your credit cards when you need help can seem like the smart move. But if using credit cards is your go-to answer, credit.org offers free credit coaching that provides you with personalized financial guidance. Our coaches review your entire financial picture, including your budget and all your debts, and help create a plan that’s right for you.
Find the Debt Solution That’s Right For You
If you’re struggling with debt, you may be looking for a way to fix things fast. While debt settlement may seem like a cure-all for your needs, there may be better options available.
Don’t make the mistake by taking the wrong financial path. Reach out to one of our debt coaches and learn how you can take control of your debts and become debt-free fast. Re-start your future today.