Debt Settlement Pros & Cons

Jun 17, 2014 by

erase credit card debtIf debt is really weighing down your finances, you’ve likely found intriguing those enticing television commercials promoting a service to slash your debts by half or more. These commercials are selling “debt settlement,” a legitimate technique for paying off seriously past due debt.

What’s Debt Settlement?

Here’s how debt settlement works:

  1. Say you have an old $5,000 debt that was written off by the original creditor and sold to a collection agency a couple of years ago.
  2. You’ve paid nothing on the debt, despite the collection agency’s aggressive tactics.
  3. Either you or the collection agency proposes a $3,000 payment to fully pay off the debt. (This works for the collection agency because it may have paid the original creditor only $1,000 for the debt.)
  4. After negotiations, you and the collector agree on a payment of $2,500 to take care of the debt.
  5. You make the payment, the debt’s balance on your credit report goes to $0, and the collection agency leaves you alone, forever.

Pros & Cons of Debt Settlement

The benefit to the collection agency of a debt settlement is that it’s booked a profit on the debt it purchased from your original creditor.

For you the benefits of debt settlement are:

  • The collection agency stops hounding you
  • A past due debt stops hammering your credit score
  • You’ve lived up to, at least in part, your obligation to repay money you borrowed

The downsides of settling a debt include:

  • A notation that the debt was settled for less than the full amount can linger on your credit report for seven years, taking a gradually fading toll on your credit rating
  • The IRS may consider the portion of the debt “forgiven” as taxable income to you


Alternatives to Debt Settlement

In my opinion, for most people most of the time, a Debt Management Plan is the best way to pay off debts. Because you’d be paying off your debts in full, a DMP would have much less negative impact on your credit score than would settlement. For the detail oriented person with good discipline, a do-it-yourself DMP may be a great option. For those who need help setting up and managing a DMP and who want to minimize their debt payments, a Plan offered through a non-profit credit counseling agency affiliated with the National Foundation for Credit Counseling is a good choice.

Do-It-Yourself Debt Settlement

If you conclude debt settlement is the best option for you, please don’t pay the high and generally non-refundable fees charged by the sponsors of those enticing television commercials. Settling a debt is not rocket science! Check out “Settle Your Debt in 10 Easy Steps“, part of the Money Counselor Simple Guides to Debt, Credit, and Wealth Series.

Have You Settled a Debt?

Have you or someone you know settled debts? What did you learn?

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  1. Travis Pizel

    here’s my issue with debt settlement:

    1.) In order to successfully settle for less than you owe, you have to stop paying your bills – which causes late fees, potential over the limit fees, and interest to continue to accumulate. Then, you settle for less than you owe, and if you’re using a service you then have to pay a “success fee.” Then the IRS will count the forgiven debt as income, which means you pay income tax. SO, between the increase in the balance (due to interest, fees, and penalties), the success fees from the debt relief firm, and the income tax – how much would a person really save, and is it worth it given the stress and credit score destruction?

  2. Fit is the New Poor

    Seven years is a very long time not to be able to have access to a good credit score, but at the same time, if you are at this point-you probably would not have the best credit score as it is.

    • Good point. The credit score impact of negative info on a credit report does fade over the seven years it’s on the report, but even 6-year old info will keep a score from being as high as it would be otherwise.

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