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Basically, debt settlement is when you pay less than the amount originally owed on a debt. Debt settlement differs from a bankruptcy, where the entire debt is wiped out; or, debt consolidation where you take several debts and consolidate them into one loan. Debt settlement is somewhere in the middle and is used for unsecured loans.

It is possible for individuals to negotiate directly with their lender to reduce the amount of the loan. However, there are companies out there that will gladly help with the negotiations, for a fee of course. If someone has several credit cards, each with a several thousand dollar balance, having a company take care of all the negotiations is worth the cost.

How it works

The way most debt settlement companies work is the consumer pays the debt settlement company a set fee each month. When the company has a sufficient amount of funds they will contact the lender and offer a reduced amount on the debt. The lender may or may not accept the offer. If they accept the offer, the loan is paid and the debt settlement company will move on to the next lender after the balance has built back up.

This process will repeat until all of the debts have been settled. For someone who is drowning in debt, this may seem like an ideal solution to their overwhelming debt problem. However, as you might expect, there is a downside to debt settlement. In fact, there are several issues to consider before deciding to go this route.

The Downside

Debt settlement will damage your credit score. Companies will not negotiate on a current account; in order to qualify a person would need to be behind on their payments. Hiring even the top debt settlement companies will not stop the collection calls or, the interest charges. When you are paying the debt settlement company, you are not paying the creditors.

When a company decides to settle a debt they are essentially giving the consumer the difference as a gift. So for instance, someone owes $10,000 on a credit card and the company agrees to take $5,000 to pay it off. That other $5,000 is treated as income to the consumer and they will be issued a 1099 at the end of the year. Companies are required to issue a 1099 for any amount over $600 and it is taxable income.

Before considering debt settlement, it is best to do plenty of research ahead of time. Check out the debt settlement company with the Better Business Bureau (BBB) to see if there are any complaints. Go to their website, read reviews, and always be careful when sending funds to an unknown party.