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The Pros and Cons of Debt Settlement

  May 29, 2024  |    #Eliminate Debt

Is debt settlement too good to be true?

Drowning in debt and feeling overwhelmed by your options? Debt settlement might seem like an enticing solution. This guide breaks down everything you need about using debt settlement to achieve financial freedom.

What is debt settlement?

Debt settlement, or debt relief, involves paying a lender a lump sum of up to 50% less than you owe. A third party, such as a debt settlement company or attorney, typically negotiates these reduced terms on your behalf.

What you should know about debt settlement

Debt settlements can eliminate between 10% and 50% of what you owe a lender, making it an attractive option for those struggling with debt. While you can negotiate your debt settlements, the process requires experience and finesse, which is why many people choose to hire a debt settlement company or an attorney.

A debt settlement company acts as an intermediary, reaching out to your lenders on your behalf to negotiate more favorable terms. If you decide to settle your debt on your own, it’s generally easier to negotiate if your payments are less than six months overdue. Once your debt is over six months overdue, it’s often sent to collections, where negotiating becomes more difficult. Collections agencies typically have little incentive to negotiate since they earn a percentage of the debt they recover from you.

Whether you negotiate a debt settlement yourself or hire a professional, being prepared to offer a large, lump-sum payment is crucial. Debt settlement companies may require you to deposit this lump sum into an account you control but managed by a third party. Despite the potential benefits, debt settlement is not without its challenges. It requires careful planning, negotiation skills, and a clear understanding of the process to achieve a successful outcome.

Debt settlement scams

Unfortunately, many individuals and businesses are eager to exploit your financial desperation for their gain. Falling victim to such scams can worsen your debt, drain your finances, and damage your credit score. Therefore, it’s crucial to thoroughly understand debt settlements before pursuing one.

Start by reading this article and listening to the Queer Money® podcast episode above for a comprehensive introduction. Additionally, before agreeing with a debt settlement company, conduct thorough research. Vet the company through reputable sources like the Consumer Financial Protection Bureau, Better Business Bureau, your state attorney general, and local consumer protection agencies. Ensure the debt settlement company or attorney has a clean record, free from complaints or any news that raises red flags. This due diligence will help protect you from scams and ensure you make informed decisions on your path to financial freedom.

Lenders and debt collectors aren’t required to consider debt settlements

While debt settlement can effectively reduce and pay off debt, it’s essential to understand that not all lenders and debt collection agencies are willing to negotiate. They are under no legal obligation to accept settlement offers, which means that debt settlement might not be a viable option depending on the specific creditors you owe.

Some lenders prefer to pursue the total amount owed through other means, such as continued collection efforts or legal action. Similarly, debt collection agencies, especially those compensated on commission, may have little incentive to agree to a reduced settlement. This can make the process challenging and, in some cases, impossible.

Before considering debt settlement, it’s crucial to research and understand your creditors’ policies regarding settlements. If your creditors are unwilling to negotiate, you may need to explore alternative debt relief options such as debt consolidation, credit counseling, or bankruptcy. Being informed about your creditors’ stances on the settlement can save you time and help you make more strategic decisions regarding your debt management plan.

What do debt settlements cost?

Hiring a debt settlement company can be a significant investment, costing you between 15% and 25% of the amount the professional saves you or the amount you owe your lender. It’s advisable to avoid agreements based on the total debt amount. Be wary of any debt settlement company or attorney offering guarantees or requesting payment upfront; such practices are illegal.

Legally, debt settlement professionals cannot charge a fee until they have successfully negotiated a settlement agreement on your behalf, agreed to the terms, and made at least one payment to your lender or collections agency. Beyond the primary fee, you might also encounter setup, initiation, and monthly maintenance fees. Attorneys may bill by the hour or charge a flat fee per creditor or collections agency.

Given these costs, debt settlement is often more suitable for those with severe financial challenges and multiple debts—typically at least four loans. For some individuals, filing for bankruptcy might be a less expensive and more effective option. It’s crucial to weigh all costs and potential outcomes to determine the best action for your financial situation.

What are the effects of debt settlement credit scores?

Many debt settlement companies advise borrowers to stop making payments on their debts. This strategy serves two primary purposes. First, it signals to lenders or collections agencies that the borrower is experiencing significant financial hardship. If lenders believe you can pay the full amount owed, they are less likely to negotiate. Second, halting payments helps borrowers accumulate savings for the large, lump-sum payment required for a settlement. Generally, the more significant your lump-sum offer, the more likely you will succeed in negotiations.

While this approach can be practical, it comes with significant risks. Ceasing payments can further damage your credit score, which might already be low. It’s crucial to understand that even if you follow the debt settlement company’s advice and stop making payments, there’s no guarantee you will secure a settlement. This could leave you with accumulated debt, increased interest and fees, and a severely damaged credit score.

Moreover, any debt settlement agreement you reach will be reported to the three major credit rating agencies: Experian, TransUnion, and Equifax. This settlement will appear on your credit report for up to seven years, indicating to future lenders that you did not repay the full amount of your debt. Consequently, this can significantly lower your credit score, sometimes to as low as 500, placing you in the “poor” credit range. This lower score can make obtaining future loans, secure housing, or even a job more difficult.

Considering these potential outcomes, it’s essential to weigh the pros and cons of debt settlement carefully. While it can provide immediate relief from overwhelming debt, the long-term impacts on your creditworthiness and financial health must be considered. Always understand the implications and explore all available options before debt settlement.

What are the tax consequences of debt settlements?

It’s important to understand that any settled or forgiven debt may be considered taxable income by the federal government, specifically the IRS. If you are forgiven for more than $600 of your debt, the lender or collections agency must report this forgiveness on a 1099-C form, and you may be liable to pay taxes on the forgiven amount. Consequently, your debt settlement’s apparent “savings” could be significantly reduced once tax obligations are factored in.

However, there are exceptions to this tax liability. If you are considered insolvent, meaning your total liabilities exceed your assets, you may be exempt from paying income taxes on settled or forgiven debt. Determining whether you qualify for this exemption and understanding how to report your debt settlement to the IRS appropriately can be complex. It’s advisable to seek guidance from a qualified tax professional who can provide personalized advice based on your financial situation.

It’s worth noting that consulting a tax professional may incur additional costs, adding to the overall expenses associated with your debt settlement. While this may increase the upfront costs, it can ultimately help you navigate the tax implications of debt settlement more effectively, potentially saving you money in the long run.

Pros and cons of debt settlement

Finding any relief in paying off debt is exciting. There are pros and cons to every option you have. Below are the pros and cons of pursuing a debt settlement.

The pros of debt settlements

  • Lower your debt by as much as 50%
  • Could make you debt free within 36 months
  • Avoid bankruptcy
  • Lenders and collections agencies will stop calling, emailing and mailing you
  • Eliminates the risk of being sued

The cons of debt settlements

  • Usually only options for unsecured, revolving debt like credit cards and not home, auto or student loans
  • It could take you years to save the amount of money you need for your large, lump-sum payment
  • Negotiating successful debt settlements could take up to 2 to 4 years
  • Stopping payments could accrue late fees, penalties and additional interest charges
  • It could ruin your credit
  • Lenders may send collections agencies your way
  • Lenders could sue you, which could result in wage garnishment
  • Your settled amount may be considered taxable income by the IRS
  • Debt settlements are neither free nor cheap
  • You may pay fees on all of your debt, not just the debt that’s settled or forgiven

Should you pursue debt settlement or file for bankruptcy?

Deb settlement can often offer more favorable outcomes for all parties involved when executed successfully than filing for bankruptcy. You can significantly reduce your debt burden and alleviate financial stress through debt settlement. At the same time, the lender recovers at least a portion of the outstanding balance, and the debt settlement company earns a fair fee for their services.

Unlike bankruptcy, which may involve liquidating non-exempt assets like your car or home, debt settlement allows you to retain ownership of your essential belongings. While bankruptcy can provide certain asset protections and may offer a faster resolution than debt settlement, it comes with the requirement to liquidate assets, which can be emotionally challenging.

Moreover, bankruptcy proceedings are a matter of public record and can have long-lasting implications on your reputation and future employment prospects. In contrast, debt settlement transactions typically involve only two to three parties, maintaining more confidentiality and privacy.

Ultimately, debt settlement offers a more personalized and collaborative approach to resolving financial difficulties, benefiting debtors and creditors alike while avoiding the potentially adverse consequences of bankruptcy.

What you should do before pursuing a debt settlement

If you pursue a debt settlement, you’ll want to do it right to make it as easy on yourself as possible. Below are the primary steps you should take.

  1. Consider all your options for becoming debt free
  2. Connect with any lenders to share your predicament and ask for lenience
  3. Consider all your options for debt settlement companies
  4. Research the history and qualifications of any debt settlement company you consider
  5. Start saving money for your large, lump-sum payment to your lenders
  6. Don’t stop payments on your debt until a debt settlement company tells you otherwise
  7. Improve your credit score

How can you avoid needing a debt settlement?

Avoiding the need for debt settlement is crucial for maintaining financial stability. Here are several proactive steps individuals can take to steer clear of debt settlement:

Minimize Debt Acquisition: While it may be challenging, avoiding debt altogether is the most effective way to prevent the need for debt settlement. Although not always possible, being mindful of your borrowing habits can help you limit unnecessary debt.

  1. Use “Smart” Debt Wisely: If you need to borrow, prioritize using “smart” debt, such as mortgages and student loans, which typically offer long-term benefits. However, it is essential to use these types of loans judiciously and avoid excessive borrowing.
  2. Communicate with Lenders: If you’re facing financial difficulties, it’s essential to communicate with your lenders proactively. Contact them to discuss potential options for leniency or alternative repayment plans. Lenders are often willing to work with borrowers to find mutually beneficial solutions.
  3. Explore Refinancing and Forbearance: Consider refinancing options for mortgage and auto loans to lower your monthly payments potentially. Additionally, inquire about forbearance or modified repayment plans, which can provide temporary relief by postponing payments or adjusting repayment terms.
  4. Pay Off Credit Card Balances: Aim to pay off credit card balances and other revolving debts monthly. Creating and sticking to a budget can help you manage your expenses and avoid accumulating high-interest debt.

Taking proactive measures to manage your finances responsibly and communicate effectively with lenders can reduce the likelihood of needing debt settlement and maintain control of your financial well-being.

Hear what we told Good Morning America about the Debt Lasso Method:

 

Look, there are many options to help you pay off your debt fast. All options aren’t for everyone, but no one’s lost. Neither are you. There’s an option.

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