If you’re struggling with a large amount of debt, the ads you see on TV and the web promising to settle your debt for a fraction of what you owe might sound very tempting. But before you decide to try this option, it’s important to understand the process, the often-high fees involved, and the effect this decision can have on your financial future.
What is Debt Settlement? Debt settlement means that either you or a debt settlement company working on your behalf negotiate with each of the companies you owe money to in an effort to get your creditors to accept a portion of what you owe as payment in full.
Usually, a debt settlement firm will have you stop paying your creditors and pay the firm a monthly amount that they will hold until you have enough to make a lump sum payment to pay off a creditor.
The Downside of Debt Settlement
- Debt settlement can hurt your credit score. While your score may have dropped because you have been making late or incomplete payments, because you stop making payments for a period of time as part of debt settlement, your credit score will take an even bigger hit. Some financial experts warn that settling your debt for less than you owe can also damage your credit score.
- Fees can be very high. Many debt settlement firms charge an upfront fee plus a percentage of your total debt or of the amount your debt is reduced by.
- You’ll owe taxes on the debt you don’t have to pay. The difference between what you owe and what you pay through debt settlement is typically considered to be income by the IRS. That means you will have to pay taxes on that amount.
- Not all debt settlement firms are trustworthy. The industry is not regulated by the federal government and there are scams where firms collect money from you but never settle your debts, so you need to be very careful.
- Your creditors could sue you. During the period when you stop paying your debts, some creditors may file a lawsuit, garnish your wages, and put liens on your property.
Other Debt Solutions to Consider
- Debt consolidation can be an option. You take out one loan and use that money to pay back all your other debts. You then make one payment per month on that loan, rather than juggling multiple payments from many creditors. In some cases, the interest rate on the debt consolidation loan is lower than it was on your individual debts, which can save you money in the long run
- Ask your creditors to lower your interest rate. If you can afford to make at least the minimum payment on your debts, contact each creditor and ask for a lower interest rate or see if they have any options to help customers who are struggling with their debts.
- Borrow from savings or family. If you have a 401(k) or IRA, there are some situations where you can borrow money from those accounts, but be sure to find out what the tax consequences and fees are. Family members may also be willing to lend you money to help you get out of debt.