What Are the Risks of Debt Settlement?

Debt settlement means offering to pay a creditor less than the full balance owed. Cambridge Credit Counseling wants you to understand the risks before you consider it: there is no legal right to settle a debt in the United States, and creditors do not have to accept an offer. Settlement can lead to fees, a negative mark on your credit report, a balance that keeps growing while you save, and a possible tax bill if debt is forgiven. It is different from a Cambridge Credit Counseling debt management plan, which works with your creditors to pay your balance in full instead.

There Is No Legal Right to Settle a Debt#

In the United States, there is no legal right to settle a debt. A creditor is not obliged to accept a settlement offer, even if a consumer stops making payments and offers a lump sum instead.

Settlement Often Requires Severe Delinquency#

In many cases, unsecured debt accounts must be severely delinquent or written off as uncollectible before a creditor will agree to a debt settlement. This means the account may already be seriously behind before a settlement becomes possible at all.

Your Balance Keeps Growing While You Save#

On a debt settlement program, money is generally paid into a special account periodically until enough has accumulated to offer a compromise on an enrolled account. While that money is accumulating, no payments are being made on the account, so it generally falls past due and ages through delinquency toward charge-off. During this period, late fees, possible over-limit fees, and penalty interest rates are typically charged, so the balance keeps growing even as you save toward a settlement.

Fees Are Added on Top of the Settled Amount#

Settlement company fees are charged on top of the settled amount. These fees are generally charged at the point of a successful settlement and can range from 15 percent to 30 percent of the savings or of the settled amount. Successful settlements themselves can range from 30 percent to 60 percent of the debt owed, and by the time a settlement is reached, many balances have grown large enough that the fee plus the settled amount can come close to the original debt owed at enrollment.

Forgiven Debt May Be Taxable#

Unless you are insolvent, debt forgiven in a settlement is taxable as income, and you will receive a Form 1099-C. When the savings from a settlement are $600 or more, not counting accrued interest and fees, the creditor must send a Form 1099 to both the IRS and you, and the forgiven principal is added to your taxable income.

Credit Report and Collection Risks#

A debt settlement will more than likely result in a negative entry on the consumer’s credit report, unless the consumer negotiates with the creditor or collector to report the account differently to the credit bureaus. The period of non-payment while money is set aside for a settlement has a deep negative impact on a credit score and on the future cost of borrowing. Many settlement programs also send a cease-and-desist letter that disconnects the relationship between the consumer and the creditor; this generally stops collection activity, except where the creditor sues the consumer for non-payment over time. Nonpayment of debt may also lead creditors to increase finance and other charges or take collection action, including litigation. A high debt-to-income ratio from unresolved debt can also make it harder to qualify for a car loan or a mortgage later on.

Watch for Re-Aged Debt#

Statutes of limitations on debt vary by state, and making a payment of any size on a debt that has passed its statute of limitations re-ages the debt and restarts the clock. This is worth knowing before agreeing to any payment during settlement talks on an older debt.

Know Your Rights With Collectors#

The Fair Debt Collection Practices Act is a federal law that prohibits collectors from using unfair, abusive, or deceptive practices, including profane or obscene language, falsely claiming they will take legal action, disclosing a debt to other parties without consent, or threatening violence or imprisonment. If a collector violates this law, a consumer may pursue legal action in state or federal court within one year of the violation and may recover damages plus an additional amount up to $1,000, along with court costs and attorney’s fees. Consumers can also report problems to their state Attorney General’s office and the Federal Trade Commission.

How a Debt Management Plan Works With Creditors#

A Cambridge Credit Counseling debt management plan takes a different approach than settlement. Our counselors work with creditors to obtain the benefits those creditors are willing to extend to their customers, rather than disconnecting the relationship. Creditor benefits on a plan can include a reduced interest rate, a reduced monthly payment, the waiving of late and over-limit fees, and the ability to bring a past-due account back to current status after three months of on-time payments. Enrolled accounts are consolidated into a single monthly payment, and balances are paid in full, with the concessions creditors have put in place. A debt management plan is not a negotiation; almost all of the benefits are preset guidelines that creditors have established for agencies like Cambridge Credit Counseling to follow.

How a Debt Management Plan Affects Your Credit#

A Cambridge Credit Counseling debt management plan can have an initial impact on a credit score, generally because the enrolled accounts are closed. How large that impact is varies with how many accounts are enrolled, how long they were open, and what other trade lines appear on the credit report. The long-term credit impact is generally positive, because the consumer is not defaulting and is paying the debts in full. As long as payments are made on time, the accounts run current, and credit scoring models treat that as positive.

When Debt Settlement Might Make Sense#

Debt settlement is a different service from credit counseling. It is typically offered by for-profit companies, though a few large nonprofit agencies now offer debt settlement too; Cambridge Credit Counseling does not offer debt settlement in any form. It tends to come up as an option when unsecured accounts are already severely delinquent or written off, since that is often when a creditor becomes willing to negotiate. The Consumer Financial Protection Bureau publishes guidance comparing credit counseling, debt settlement, debt consolidation, and credit repair, which can help consumers understand how these paths differ before choosing one.

What to Do Next#

Cambridge Credit Counseling offers a free, one-on-one debt evaluation with our nationally certified credit counselors, with no obligation, to help you find out whether a debt management plan could be a better fit for you. A debt settlement evaluation is also typically free and creates no obligation, but a Cambridge Credit Counseling plan and a debt settlement program are priced differently. A Cambridge Credit Counseling debt management plan’s fees are set within the maximum each state allows, based on what a household can afford, and we explain them before you decide whether to enroll. A settlement program’s fees are generally charged on top of the settled amount and can range from 15 percent to 30 percent of the savings or of the settled amount. On the balances and rates our clients actually brought us, the same debts would have cost $44,676 in interest and taken 272 months to pay off at their original terms; on a Cambridge Credit Counseling debt management plan, those same clients are projected to pay $4,936 in interest and our fees. Cambridge Credit Counseling is a nonprofit agency that offers credit counseling, debt management plans, housing counseling, student loan counseling, reverse mortgage counseling, and bankruptcy counseling.