What to know about credit card debt settlement

What if we told you that you could rid yourself of all your debt with one lump sum of cash? It’s not a crazy idea. Sometimes, creditors are willing to settle a debt for less than what is owed when people can’t pay the full amount.

Credit card debt settlement is one way people eliminate their debt by paying only a portion of the total debt. However, while you can negotiate ways to get out of debt more cheaply or quickly in this way than you would by paying your credit cards off over time, it’s important to know how settling impacts your credit.

Understanding how debt settlement works and what it might do—or not do—to your credit is critical to knowing if this is the right step for you. Let’s talk about the risks that come with debt settlement.

What is debt settlement?

Debt settlement is the process of negotiating with a lender to pay off your debt for only a portion of what you owe. Lenders have the right to decide whether they want to negotiate a settlement with you, so it’s not always an option when you’re trying to get out of debt. It’s not a bad idea to check with your lender when you’ve fallen behind on your payments, however, so you can minimize the impact your overdue debt may have on your credit score.

If you’re able to come to terms with a lender, your credit report will reflect this. The debt will show as “settled” on your report instead of “paid.” When a debt is listed as paid, it means you paid the entire amount you owed. Conversely, settled status tells other lenders that you negotiated a settlement. Open status means you’re still making payments on your debt and haven’t settled.

How debt settlement works

Debt settlement can help people who have fallen behind on their payments, missed their payments or had their payments go to collections.

Generally speaking, the longer a debt is unpaid, the less likely it is for a debtor to collect the full amount owed, meaning they’re more motivated to take partial payments. Plus, if you’re in collections, the amount owed might have been inflated substantially by fees and interest. Collectors will often accept a lower amount to get much of the original debt balance back.

If your payments are current, a lender probably won’t accept less than you owe, so debt settlement might not be an option for you. However, you may be able to ask about hardship programs or forbearance.

What to expect during the debt settlement process

Even though lenders might be motivated to get something instead of nothing, the debt settlement process isn’t easy, and it can be lengthy.

Expect creditors to want you to be very far behind on payments before they’re willing to talk about a settlement. But be proactive—don’t wait until the creditor has sued you. If you do, they may move to garnish your wages until they get the total amount back.
Expect to meet a deadline when making a settlement payment. Creditors might agree to take much less than what you owe if you pay immediately or within a short time period, such as a few days or a week. Save up money to make this possible if you’re planning to negotiate a settlement.
Expect your credit to suffer. Since you have to be substantially behind on payments, your credit score will have been impacted by any late payments or collections. A debt settlement may also appear as a negative item on your credit reports.
Expect to get things in writing. Don’t fork over the agreed-upon amount until you get it in writing that the creditor agrees to accept it as payment in full.

When is debt settlement right for you?

You shouldn’t consider debt settlement unless you’ve already fallen behind on your payments. Settling with the credit card company can limit the number of derogatory marks you receive on your credit report linked to that debt. If you’re behind on your payments, the credit card company may consider taking a partial payment because it would be more time-consuming and expensive to send you to collections.

A settled status on your credit report may lower your score, but it won’t hurt your credit as much as being sent to collections might. Be careful if you attempt to negotiate a settlement, however, so that you know exactly how it will affect your credit and whether the deal is beneficial for you.

The different types of debt settlement

When considering credit card debt settlement, you may be offered one of the following types of settlements.

A workout agreement

If you've fallen behind on your credit card payments, you may be required to pay a higher interest rate, late fees and other penalties. A workout agreement doesn’t eliminate your principal, but it does help you pay it off with a reduced interest rate and fewer fees. The credit card company may offer to forgive the fees and reduce your interest when you show you're interested in paying off your entire debt.

The problem with a workout agreement is that if you don’t hold up your end of the deal, you could face even stiffer penalties than before. The credit card company may also refuse any future settling attempts. Therefore, make sure that if you agree to a workout agreement, you know you can afford to make the agreed-upon payments.

A lump-sum settlement

In some cases, a lender may be willing to discount what you owe if you offer a lump-sum settlement. You agree to pay one amount immediately and the debt is eliminated at a discount. One example would be if you owe $5,000 on your credit card and agree to pay $3,500. The $1,500 difference is considered debt forgiveness, and the IRS may tax you on it.

If you agree to pay a lump sum to eliminate one of your debts, make sure you’re aware of the tax implications. Set aside extra money to pay your tax bill if you’re not expecting a refund.

A hardship agreement

Because life is unpredictable, you may be experiencing financial difficulties due to circumstances beyond your control. If you’re unable to make your payments due to medical bills, job loss or another economic hardship, your credit card company may be willing to work with you through a hardship plan. These plans vary by lender, but they usually allow you to create a payment plan to catch up or pay your debt off at a discount.

Debt settlement programs

Some companies offer debt settlement programs, stating that they will resolve your debts for a fraction of what you owe. In reality, there’s no magic solution here. These companies simply charge you to do what you can do yourself in negotiating with creditors.

The benefits of working through a debt settlement program are that someone handles a lot of the time-consuming tasks for you, and some companies might be better at negotiating with aggressive creditors. The downsides are that they can be expensive, and sometimes, these services are scams. If you plan to work with a service, make sure you research it and know what you’re paying for.

Negotiating your debt

Although the best way to protect your credit is to make all your payments on time, life happens. Before you pin your hopes on debt settlement, remember that the credit card company doesn’t have to settle with you if they don’t want to. To make matters worse, you may not always be offered terms that are in your best interest. You also need to protect yourself against scams.

Should you negotiate a settlement?

There are alternatives you may consider before reaching out to your credit card company to negotiate a settlement. You could consolidate your debt and pay a lower interest rate, for example. Whether it’s a good idea to negotiate depends on your circumstances and whether your credit already has suffered due to late payments.

How do you negotiate your credit card debt?

Some debt relief services offer to negotiate with your credit card companies for you, but they don’t do much you can’t do yourself. If you want to negotiate on your own, you can follow this process:

Check your payoff amount so you know what you owe before you contact the lender.
Consider what type of settlement works best for you.
Call the credit card company and explain that you want to negotiate your debt.
Negotiate terms with the credit card company.
Take notes and be sure to follow up on any steps you need to take. Make sure you get all the details in writing.
Be wary if the credit card company won’t give you written acknowledgment of the agreement or demands money before you’ve agreed on terms.

How to identify debt settlement scams

There are many scammers looking to take advantage of people who want to get out of debt. Therefore, be wary of debt relief companies that make promises that seem too good to be true. You should never pay money up front when trying to negotiate debt. Be especially wary if you receive an unsolicited phone call or text message from anyone claiming they can eliminate your debt.

If you’re ever told that a company can remove your debt from your credit history, this is another sign you’re being scammed. It takes time to remove negative information from your credit report. Legitimate credit repair companies can help you make better decisions when you begin the credit repair process.

Common questions about debt settlement

Does debt settlement affect my credit score?

In most cases, your credit score will have already been affected by late payments, delinquencies and collections related to the debt you want to settle. While settling the debt results in a charge-off being reported on your credit history, it’s not typically as huge of a hit beyond what you’ve already experienced. It sounds scary, but settling this matter and moving on may help you make more positive credit and financial choices in the future.

Do I have to pay taxes on my settlement?

The IRS considers forgiven debt to be a form of income, which means you can owe taxes on it. Typically, the debt has to be more than $600 to be reported as income to the IRS. So, if you owe $10,000 and a creditor agrees to settle for $6,000, you could be on the hook for paying taxes on $4,000. Work with your tax adviser to determine your tax responsibility.

Are there better alternatives to debt settlement?

The best alternatives for you really depend on your financial situation and goals. Other options include debt consolidation loans, balance transfer credit cards and asking the credit card company for assistance before you start falling behind on bills. If you owe a lot of debt and can’t afford to make payments, you might want to talk to an attorney about additional options like bankruptcy. Be aware of your various options and which work best for your individual situation.

Are there debt settlement risks?

If you’re not very careful and clear in your agreement, you might not be getting what you think you are. If you don’t have it in writing that the debtor agreed to settle for a certain amount, they might keep chasing you for the rest of what you owe.

Repairing your credit after debt settlement

If you decide to move forward with a debt settlement, know that it doesn’t automatically clear this item from your credit history. However, it does open the door for you to begin repairing your credit.

And know that no matter what items are on your report, you have rights as a consumer. If you see any items that are inaccurate—or if a lender has misreported anything—we know someone who can help you work to dispute it.

(spoiler: it’s narrow-pathconsulting.com).