What is Debt Settlement?
Debt settlement is an arrangement between the lender and the borrower, according to which the borrower pays a lump sum or one-time payment which is less than the actual amount due, to settle the debt once and for all. These services are provided by third-party companies who negotiate on the borrower’s behalf with the creditor on settlement terms. This is a high-risk option and leads to a sharp decline in borrower’s credit rating.
If a debtor is struggling to pay its unsecured debt like credit card debt, personal loans, etc. they can approach debt settlement companies. These companies negotiate on the borrower’s behalf to settle the debt with a reduced amount. This company holds the payment from the debtor to settle the debt in the negotiation period. And when the debtor is in default on all the accounts, these companies can force the creditor to accept reduced lump sum amount for settlement of their debt.
This leads to a sharp decline in the debtor’s credit rating in the negotiation period when the debt settlement company is holding the payment from the creditor, which will have an impact on several years. Still, some debtors prefer this over bankruptcy.
How Does it Work?
Debtors struggling to pay their debts reach out to debt settlement companies. This service is offered by a third-party company unrelated to the creditor. These companies offer to negotiate the term of debts with creditors on the debtor’s behalf. They negotiate for either better payment terms or settlement of debt with a reduced amount.
This company instructs the debtor to make a regular deposit to a separate account and withholds payment till the payment term is negotiated with the creditor. This deposit help debtors later at the time of the final settlement. Once the terms are negotiated, the company asks the debtor to make a lump sum settlement for one of their debt for the reduced amount. And they charge a percentage of fees on the amount that the debtor saves.
Let us take an example of a financially struggling debtor who is unable to pay his monthly unsecured loan and has no balance left in his account. The debtor has monthly earnings of $10,000, but after meeting all the necessary expenses, $5,000 is left at his disposal, which is insufficient to pay the monthly debts of $7,000.
Now debtor reaches out to the debt settlement company to negotiate on his behalf with the creditor for better payment terms or settle the debt by paying a lower amount. The company will advise the debtor to make a regular payment of $5,000 in a separate savings account and stop paying the creditor altogether.
After let’s say four months, the settlement company would have collected $20,000 from the debtor. At that time, it will ask the creditor to accept the lump sum payment of $15,000 on the debtor’s behalf and settle the debt. The creditor did not receive the payment for the last four months. Therefore they may have written off the amountWritten Off The AmountWrite off is the reduction in the value of the assets that were present in the books of accounts of the company on a particular period of time and are recorded as the accounting expense against the payment not received or the losses on the assets. and can accept the lump sum payment of $15,000 to settle the debt. This will forward $15,000 to the creditor and will keep $5,000 as its fees.
- This option will severely impact the debtor’s credit riskCredit RiskCredit risk is the probability of a loss owing to the borrower's failure to repay the loan or meet debt obligations. It refers to the possibility that the lender may not receive the debt's principal and an interest component, resulting in interrupted cash flow and increased cost of collection. rating, and the mark will remain for several years.
- The debtor will have to pay high settlement fees to the debt settlement company.
- Even after reaching out to the settlement company, the debtor will have to continue to pay the monthly payment for a long duration.
- There is no guarantee of success in getting a negotiated term.
Alternatives to Debt Settlement
- Do It Yourself: Debtor can try negotiating the settlement with creditors on their own by offering the amount that they can pay immediately, typically less than what is due.
- Transferring the Balance: The debtor can avail of an introductory offer on a new card of 0 % or lesser interest for the promotional period and can transfer the balance. But they should ensure to pay the debt in the promotion period to avoid paying high interest.
- Non-Profit Credit Counseling: Debtors can reach out to non-profit payment counseling agencies as they do not charge hefty fees. However, they don’t negotiate for reducing the debt. They negotiate for better payment terms and cessation of late payment fees.
Debt Settlement Vs. Debt Consolidation
- Debt Settlement is the settlement of debts by paying a lump sum amount, which is less than the actual debt amount. The service is provided by a settlement company, a third party against a fee, which is typically a percentage of the remaining debt or the saved amount.
- Debt consolidation option is a process of combining several debts into one and taking out a single loan with a lower rate of interest and lower monthly payment to pay the debt. This option is availed by debtors to manage their secured as well as unsecured debts.
- It saves the debtor from bankruptcy and its stigma.
- It helps the debtor to finally pay off the debt and get creditors off their back.
- It lowers the total debt amount.
- It severely impacts the debtor’s credit score.
- These companies charge hefty fees, and thus, it can cost more to the debtors.
- There is no guarantee that the debt settlement company will be able to negotiate for reduced debt.
- There can be tax consequences for the amount that was not paid to the creditor under the negotiated settlement term.
- There is a potential risk of a lawsuit from the creditor’s side.
This has been a guide to What is Debt Settlement & its Definition. Here we discuss the example of debt settlement, risks, and how it works along with advantages and disadvantages. You can learn more about from the following articles –