If you are struggling with your finances, maxed out your credit cards, and can't afford to pay all your bills, you might consider working with lenders to resolve all or a portion or your debt.
Settling debt can relieve you of some of your financial responsibilities and help you stay in strong financial health, but there are also downsides to consider, such as how it may affect your credit score.
Some strategies for resolving debt are more effective than others. With credit card balances, for example, you might have an opportunity to negotiate what you actually owe. In some cases, you can cut your balances by as much as 50% to 70%, but a lender may not accept a lump sum payment that is too small. Lenders are not legally obligated to lower your outstanding credit.
Learn how you can more effectively settle your debt with creditors with minimal impact to your credit.
- Debt settlement is an agreement between a lender and a borrower in which the borrower repays a portion of a loan balance and the remainder of the debt is forgiven.
- You may need a significant amount of cash to settle your debt.
- Consider starting debt resolution by offering to pay 25% of your outstanding balance in return for forgiveness on the remaining balance.
- Debt settlement can negatively affect your credit score, which can make it more difficult for you to secure financing in the future.
- Debt relief companies can help you resolve debt, but be aware of the potential for scams.
How Debt Settlement Works
Debt settlement is an agreement between a lender and a borrower for a large, one-time payment toward an existing balance in return for the forgiveness of the remaining debt. It is often used when a borrower cannot pay for unsecured debt like credit card debt.
If you are in a situation in which you have a substantial lump sum of money, like $10,000, and you have spiraling credit card debt, debt settlement may be a good option to improve your financial health. For example, if you owe $20,000 on a credit card, you may want to contact the credit card company and offer to pay $10,000 in return for debt forgiveness for the remaining $10,000.
The credit card issuer ultimately wants to protect its bottom line. So they may agree to a debt settlement to try to avoid more losses of you failing to pay the full balance.
About half of debt settlement cases are resolved, according to Federal Trade Commission (FTC) estimates.
You can try to negotiate debt settlement on your own, but it's typically done through third-parties like debt relief companies, which negotiate on your behalf. With this method, you will make payments to the debt settlement company along with fees.
Once you’ve finalized your debt settlement with your lender, get the agreement in writing. If a credit card company only verbally agrees to a debt settlement, they can still legally turn over the remaining balance to a collections agency, which can have a larger impact on your credit score than a settlement.
The Risks of Debt Settlement
Although a debt settlement has the advantage of improving your current financial situation and cash flow, there are risks and downsides to consider.
First, a debt settlement will affect your credit score. This will make it more difficult for you to get credit or good interest rates in the future. A debt settlement will typically remain on your credit report for seven years and you cannot remove it before then. Although settling a debt will have less impact on your score than failing to pay completely.
Another drawback for many people is that debt settlement requires you to have a substantial amount of cash on hand. If you don't have that money, you will need to consider how you will get the funds. Debt settlement companies often have you make regular payments to them toward an escrow-like account to be used for the payment to the credit card company.
Another potential drawback is that when you settle debt, you could face tax consequences. For example, if you settle a $20,000 debt for $10,000, you may have to pay income taxes on the remaining $10,000 that you had owed.
Finally, when you settle a debt, you risk having your credit card account closed after the settlement is complete. So you could potentially have no credit line and no ability to use a credit card to make purchases.
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Debt Negotiation Tips
Whether you use a professional or not, you'll want to explain your financial situation to your lender. If your lender understands that you cannot pay your bills, they will be more likely to work with you on a solution to avoid you failing to pay make it less likely that they reject your offer.
You should also avoid spending with a credit card that has a balance you want to settle. Lenders are less likely to settle if your credit card statement includes, for example, several charges for luxury goods. To improve your chance of success negotiating with a credit card company, try to avoid using it for three- to six-months before you request a settlement.
What Percentage Should I Offer to Settle Debt?
Consider starting debt settlement negotiations by offering to pay a lump sum of 25% of your outstanding balance in exchange for debt forgiveness. However, expect the credit card company to counter with a request for a greater amount.
Do Settlements Hurt Your Credit?
Debt settlement can help you financial situation, but it can hurt your credit score and make it more difficult for you to get financing in the future. With a lower credit score, you may find that you only qualify for loans with higher interest rates, which will add to your total borrowing costs.
How Do You Remove Debt Settlement From Your Credit Report?
When you settle an account with a lender, it will remain on your credit report for about seven years and will negatively affect your credit score. You cannot remove debt settlement from your credit report before then.
The Bottom Line
You can potentially lower your credit card debt by negotiating with a lender either on your own or with a debt settlement company, but keep in mind that a creditor is not legally obligated to settle on a different payment amount other than what you owe.
If you cannot lower your total debt obligations, you can turn to other strategies that can help you stay in good financial health. For example, you may want to ask your credit card company if it can lower your card’s annual percentage rate (APR), reduce your monthly payment amount, or provide an alternative payment plan. You can also consider debt consolidation through an additional loan that results in lower monthly payments.
For more guidance on the best options for your specific situation, consider consulting a professional financial advisor.