If you have found yourself buried in debt like thousands of other Americans, you may have been bombarded by debt settlement advertisements and given this option some consideration. While settling your debts may seem like a perfect solution to your debt problems, there are numerous factors with potential consequences that need to be considered prior to taking the financial plunge into debt settlement.
Understanding Debt Settlement
According to Liz Weston of MSN Money, people sometimes confuse debt settlement with debt consolidation and credit counseling. Debt consolidation involves taking out one large loan to pay off all of your smaller debts, and credit counseling involves agencies that attempt to arrange low-interest repayment plans with creditors, allowing you to pay off your credit card debt over a period of time.
Settling your debts, on the other hand, can involve numerous ways to negotiate new agreements with your creditors, all of which can put a serious dent in your credit score. Regardless of whether a company is able to negotiate a partial payment and forgiveness of the rest of your debt balance, arrange a forbearance that allows you to not make any payments for a period of time, or renegotiate lower payments and interest rates, the company will charge a steep fee for this service and your credit score can be seriously compromised.
Effects of Settling Your Debt
When you settle your debts with creditors, these settlements are typically reflected on your credit report, resulting in a lower credit score and making it much more difficult to be approved for a loan or receive competitive interest rates in the future. In addition to these consequences, if your debt is settled for less than the amount that is owed, which is typically the case, the IRS will consider this income and you will likely have to pay taxes on the amount that you saved.
Due to the harmful effects of debt settlement, TopTenReviews only suggests this option if:
• You have already cut your budget as much as possible and can’t make your monthly payments.
• You have attempted negotiating with your creditors yourself.
• You have already considered debt counseling and debt consolidation.
• You own a home and have already looked into a home equity loan.
• You don’t fear tax time.
• You’ve weighed the pros and cons of bankruptcy.
Since settling your debts can negatively affect your credit score, the process is not much different from filing for bankruptcy. Many people fail to recognize this, but at least with bankruptcy, you will save yourself from expensive fees and payments to creditors. You will also be able to start with a clean slate, although it may be several years down the road.
That being said, some debts are better candidates for settlement than others. Typically, settlement should only be an option for unsecured debts, such as credit card bills or medical bills. With secured debt, such as a mortgage or auto loan, creditors will typically avoid negotiations and simply take your property as collateral. Also, older debt that is approaching the statute of limitations can usually be settled for the best terms.
Settlement Companies: A Word of Caution
Consumers who find themselves considering settling their debts often turn to companies who promote themselves as being settlement specialists. If you’re considering this as well, you should choose this option carefully.
“Areas hard hit by the subprime mortgage meltdown are prime targets for debt relief ads. What these companies do is make offers to your creditors to satisfy unsecured debts for significantly less than you owe. Despite the claims, settlement is not an easy way to slash debt, doesn't always work and could wreak havoc on your credit score,” says Leslie McFadden of Bankrate.com.
These companies may make bold claims and promise you the world, but they can cost you significantly more than if you negotiated with your creditors on your own. Most experts agree that consulting with a credit counselor who is approved by the U.S. Department of Justice is a much more preferable option than trusting your finances to a company you know very little about.