An agreement between a creditor and a borrower in which a reduced payment from the borrower is regarded as full payment
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A debt settlement refers to an agreement reached between a creditor and a borrower in which a reduced payment from the borrower is regarded as full payment. In other words, a debt settlement is a debt reduction agreement reached between a creditor and borrower.
Understanding a Debt Settlement
A debt settlement is entered into by a borrower when they lack the capacity to pay the outstanding amount of debt to their creditors. Instead of declaring bankruptcy, the borrower may attempt to reach a debt settlement with their creditors.
In a debt settlement, the borrower may engage with a debt settlement company, who would act on the borrower’s behalf. The typical process for a debt settlement is as follows:
The borrower explains their financial situation to a debt settlement company.
During the process, the debt settlement company would advise the borrower to stop making payments to their creditors and instead make payments to the debt settlement company (albeit at a lower payment rate).
The debt settlement company would put the payments made by the borrower into a savings account.
Once the savings account’s reached a certain threshold, the debt settlement company would engage with the borrower’s creditors to negotiate a debt settlement.
If negotiations are successful, the debt settlement company would retain a portion of the money in the savings account (it is collected as fees by the debt settlement company) and distribute the remainder to the borrower’s creditors.
Practical Example
A borrower is required to make monthly debt payments of $10,000 to her creditor for a period of three months. The debt payment schedule is as follows:
Due to unforeseen events, the borrower is unable to satisfy the debt payment schedule shown above – the borrower is left with $0 in her savings account but earns a monthly disposable income of $8,000.
The borrower engages with a debt settlement company, who advises the borrower to withhold debt payments to her creditor and to instead make debt payments to the debt settlement company. The debt payment schedule proposed by the company is as follows:
After three months of making payments to the debt settlement company, the debt settlement company has collected a total of $24,000 from the borrower. The debt settlement company calls the borrower’s creditor and negotiates a lump-sum debt payment of $20,000 to satisfy the previously required monthly debt payments of $10,000.
The creditor, having written off the borrower due to non-payments for three months, accepts the lump-sum payment of $20,000. As such, the debt settlement company forwards $20,000 on behalf of the borrower to the creditor to satisfy the debt. For helping the borrower settle the debt, the debt settlement company retains the remaining $4,000 as a fee.
Advantages of a Debt Settlement
1. Lowering the amount of debt outstanding
A debt settlement would lower the amount of debt outstanding. In the example above, although the borrower owed $30,000 in debt, the borrower only ended up paying $24,000.
2. Avoiding bankruptcy
A debt settlement allows the borrower to avoid bankruptcy. Depending on the country, consumer bankruptcy can last up to ten years – significantly impacting the credit score of a borrower. In addition, declaring bankruptcy can potentially impact employability.
Implications of a Debt Settlement
Although a debt settlement lowers the amount of debt outstanding and allows the borrower to avoid bankruptcy, there are significant repercussions to be considered, such as:
1. No debt settlement
There is no guarantee that the debt settlement company would be able to reach a successful settlement with the borrower’s creditors. In fact, according to the Credit Counselling Society, the success rate of for-profit debt settlement companies is less than 10%.
2. Legal action by creditors
While the borrower is making debt payments to a debt settlement company and not its creditors, creditors could pursue legal action or enlist the help of collection agencies.
3. Adverse impact on credit score
A debt settlement is noted on the borrower’s credit report and adversely impacts the credit score of the borrower.
4. Additional debt accumulation
When the borrower is not making the required debt payments to creditors, interest may accumulate on that debt. If a debt settlement falls through, the borrower will end up with more than the initial debt owed.
More Resources
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Debt settlement is when your debt is settled for less than what you currently owe with the promise that you'll pay the amount settled for in full. Sometimes known as debt relief or debt adjustment
debt adjustment
Debt adjustment is a form of debt relief that allows a government, organization, corporation, or individual to repay a debt over a longer period of time and with smaller payment amounts than the lender and borrower originally agreed upon.
Debt settlement might be a suitable way to manage your overwhelming debt, but it could also drive you even deeper into a financial hole, bottom out your already-damaged credit score, and put you in legal peril. So be careful. Debt settlement is risky business. Check into all your other options before you go there.
Most unsecured debt is eligible for debt settlement … if the creditor agrees! The creditor is under no obligation to accept a settlement proposal. Unsecured debt includes things like credit card debt, store cards, personal loans, medical bills – any debt that isn't tied to property that the creditor can take back.
Debt settlement typically has a negative impact on your credit score. The exact impact depends on factors like the current condition of your credit, the reporting practices of your creditors, the size of the debts being settled, and whether your other debts are in good standing.
If a credit card account remains open after you've paid it off through debt consolidation, you can still use it. However, running up another balance could make it difficult to pay off your debt consolidation account.
Start by lowballing, and try to work toward a middle ground. If you know you can only pay 50% of your original debt, try offering around 30%. Avoid agreeing to pay an amount you can't afford.
How Long After a Debt Settlement Can You Buy a House? There's no set timeline for how long it takes to get a mortgage after debt settlement. Your ability to qualify for a mortgage will depend on how well you meet the lender's requirements on the issues raised above (credit score, DTI, employment and down payment).
If you do it right, debt consolidation might slightly decrease your score temporarily. The drop will come from a hard inquiry that appears on your credit reports every time you apply for credit. But, according to Experian, the decrease is normally less than 5 points and your score should rebound within a few months.
It is not unusual for the entire debt settlement process to take three to four years. Your attorney or debt settlement company will need time to negotiate with your creditors. The more creditors you have, the more time it will take.
Creditors are not legally required to settle for less than you owe. Stopping payments on your bills (as most debt relief companies suggest) will damage your credit score. Debt settlement companies can charge fees. If over $600 is settled, the IRS will view this debt as a taxable income.
Completion rates vary between companies depending upon a number of factors, including client qualification requirements, quality of client services and the ability to meet client expectations regarding final settlement of their debts. Completion rates range from 35% to 60%, with the average around 45% to 50%.
Despite the potential downside, settling a debt by making partial repayment is better for your credit (and peace of mind) than neglecting it and leaving it unpaid. If you ignore a debt, the creditor will typically turn it over to a collection department or third-party collection agency.
What is the difference between settled vs paid in full? A settled account means the creditor or debt collector settled for less than the full amount of debt that was originally owed. If an account is paid in full, it means the full debt amount, plus interest and fees, was paid off.
While the effects of bankruptcy hang around for 7 to 10 years on your credit report, that's not how long you must wait to borrow money. The impact of the penalty decreases each year, and it's even possible to get a car loan within six months of your discharge. But that might not be the wisest course of action.
Debt settlement, when you pay a creditor less than you owe to close out a debt, will hurt your credit scores, but it's better than ignoring unpaid debt. It's worth exploring alternatives before seeking debt settlement.
If you're one of the millions of Americans struggling to repay high-interest debt, a debt relief plan may be an option to help you get your finances on track. But it's not a quick fix. It's a long-term solution designed to help you get out of debt over a period of time — typically several years.
Having a charge-off on your credit report can negatively affect your ability to get future loans. So consider either paying down your charge-off loans as soon as possible or negotiating with the lender for a pay-for-delete agreement to remove it from your credit report.
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