Definition of Debt Settlement
Debt settlement is the negotiation between creditor and debtor, whereby the debtor agrees to pay a reduced balance, which will be considered as the full payment. This agreement is often for 40-60% of the original balance and is negotiated only after the debtor has stopped making monthly payments. To a debtor, debt settlement is often the only way he or she can pay off a high balance that has accrued due to interest, late fees and other surcharges.
Rather than suffer the long-lasting ramifications of declaring bankruptcy, the debtor can have a fresh start. To a creditor, debt settlement is a way of extracting some sort of payment from a delinquent borrower and recouping at least some of the lost assets. In bankruptcy, the creditor may not receive any money whatsoever, so a settlement is better than nothing.
Video: How Debt Settlement Works
Why Does Debt Settlement Eliminate Debt?
It can be hard to believe that creditors would accept anything less than what you owe. However, they will often settle for as little as 40 cents on the dollar because they would lose even more if they sold your account into collections. Often collection agencies buy the debt for 7 – 10 cents on the dollar. Additionally, lenders that have an abundance of non-performing accounts appear to be making risky decisions, thus damaging their reputation with the Federal Reserve Board. Once the account is considered “paid,” they can cross you off the books.
Can Debt Settlement Damage Your Credit History?
The quick answer is “Yes,” debt settlement can damage your credit history. There are several ways this might occur. For one, you can’t negotiate your debts while you’re still making monthly payments. When it comes to credit scores, [http://www.pueblo.gsa.gov/cic_text/money/creditscores/your.htm] the worst offense is missing a monthly payment (which accounts for 35% of your overall score). Some debt settlement companies have you send in affordable monthly payments for several months, saving your money in a debit account until you’ve accumulated enough to bargain with, and then they’ll strike a deal with one of your creditors to settle. In the meantime, you’ve missed several consecutive payments with them – not to mention any other creditors you may have, which will lower your score. If you’ve already missed these payments, your score probably won’t be affected much more than it has been.
There are other reasons your credit score may go down. If you decide to close credit card accounts, it will decrease your “total available credit,” which will also make it appear as though you are using a bigger portion of your credit limit. If you close an older account, then you will also appear to have a shorter credit history. These are all small hits, but hits nonetheless. You don’t have to close out your accounts but often creditors will do this for you if you haven’t paid.
Your report will note that you settled for less than the full amount and it will also update your activity to the date you paid it off, which could extend the amount of time the negative hit appears on your credit report. For instance, if you hadn’t paid on your Visa bill since 2003, this debt would automatically be discharged off your report in 2010, as mandated by law – even if you didn’t pay a dime. However, if you decided to settle in 2006, due to mounting pressure from collection agencies, this information would be on your credit report until 2013 – seven years after the last account activity.
However, once your accounts are settled, your score will begin improving. The two most recent years factor heavily into your overall score too, so if you get back on track and make all your monthly payments, you can rebound to an extremely high credit score within two years. Had you declared bankruptcy, no one would extend any credit to you before three or four years’ time and you would have that negative hit on your credit report for ten years. In addition to tax liens, house liens and court judgments against you, bankruptcy is the worst thing you can do to your credit score.
Can You Settle Your Own Debt Directly?
Yes, you may decide to settle your own debts directly with your creditors. They won’t make arrangements until you’ve already been delinquent and they often demand that you pay in one or two lump sums. For instance, if you owed $8,000, they would typically say, “Ok, we’ve agreed to settle with you for $4,000 if you can pay that amount today.” If you can’t they might say, “Well we can settle for $5,500 if you can make two monthly payments of $2,250.” The problem is that it’s extremely difficult to convince creditors to accept a repayment schedule longer than a few months.
You can certainly research scripts and letters that will help you when dealing with creditors. Although the benefit of going to a debt settlement company is that these people eat, sleep and breathe negotiation skills. They know how much creditors will accept, how they think and the best way to secure a deal. In the end, either way, you will have a net savings so sometimes it pays to hire an experienced professional.
How Much Can You Save Through Settlement?
On average, people save between 20-60% of the total balance. Some of the most successful debt settlements have taken $36,000 debt down to $5,000. Of course there are usually debt settlement fees to consider as well. These vary from flat-rate monthly charges to a percentage of the debt. For instance, one debt settlement place takes in 14% of the total debt owed, so someone owing $10,000 would pay $1,400 for the settlement. Of course, if they saved 40%, their debt would be reduced down to $4,000 (plus the $1,400 fee), bringing their total net savings to $4,600.
Video: Credit Counseling or Debt Settlement?
Advantages of Debt Settlement over Debt Management Programs,
Debt Consolidation and Bankruptcy
Proponents of debt settlement argue that this method is better than a debt management program (DMP) because it discharges the debt much quicker. For people with larger debts, they need to put these high balances behind them before they can even begin to consider learning how to manage their money. The focus of debt settlement is immediate savings, whereas the focus of a DMP is long-term savings.
For some people, debt settlement can be better than debt consolidation because they are not obligated to pay back the full amounts owed. In some cases, with debt consolidation you can also negotiate savings, although the main focus of debt consolidation is to reduce high interest charges to save. If the current balances are the real problem, then debt consolidation may not be enough.
Debt settlement is almost always a better alternative than bankruptcy. With debt settlement, one can regain purchasing power within a few years, rather than the ten years it takes for bankruptcy to vanish from credit reports. Bankruptcy is sometimes tied to other assets as well, forcing debtors to sell off personal belongings to pay back some of the creditors. Newer bankruptcy types force debtors to repay some of their debt anyway – yet the financial ramifications are still severe. With settlement, it’s a mere credit blemish that will be significantly diminished within two years and obsolete within seven.
Disadvantages of Debt Settlement over Debt Management Programs,
Debt Consolidation and Bankruptcy
Critics of debt settlement argue that it doesn’t address the main reason the borrower got into trouble in the first place, thus dooming the delinquent into making the same mistakes over and over again. By contrast, a debt management program will teach budgeting and how to save, providing individuals with all the tools they need to be financially savvy. Learning to manage money can be very empowering.
Debt consolidation is a better option than debt settlement for those who are worried about credit scores. Since the borrower will pay back all he or she owes and will focus their efforts on making timely payments to creditors, the positive information will be recorded on credit reports. Sometimes creditors will agree to allow the debtor borrowing privileges again if he or she pays on-time each month and in full. Whereas, with debt settlement, the report will indicate that the individual paid less than the full amount owed and the account will likely be closed out.
Bankruptcy is the only answer for people who are in extremely heavy debt. Sometimes the figure is so high a person can never pay it back. For instance, a person making minimum wage in Wyoming ($9,888/year) will never be able to pay back a $90,000 medical bill. Medical expenses, divorces and job losses are the top three reasons for declaring bankruptcy.
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