What is Debt Settlement?

Debt settlement is an arrangement between the lender and the borrower, according to which the borrower pays a lump sum or one-time payment, which is less than the actual amount due to settle the debt once and for all. These services are provided by third-party companies who negotiate on the borrower’s behalf with the creditor on settlement terms. It is a high-risk option and leads to a sharp decline in borrowers’ credit ratings.

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Explanation

If a debtor is struggling to pay its unsecured debt like credit card debt, personal loans, etc., they can approach debt settlement companies. These companies negotiate on the borrower’s behalf to settle the deficit with a reduced amount. This company holds the payment from the debtor to pay the debt in the negotiation period. And when the debtor is in default on all the accounts, these companies can force the creditor to accept a reduced lump sum amount to settle their debt.

That leads to a sharp decline in the debtor’s credit rating during the negotiation period when the debt settlement company is holding the payment from the creditor, which will have an impact for several years. Still, some debtors prefer this over bankruptcy.

How Does it Work?

Debtors struggling to pay their debts reach out to debt settlement companies. This service is offered by a third-party company unrelated to the creditor. These companies offer to negotiate the terms of debts with creditors on the debtor’s behalf. They arrange for better payment terms or debt settlement with a reduced amount.

This company instructs the debtor to make a regular deposit to a separate account and withhold payment until the creditor’s payment term is negotiated. This deposit helps debtors later at the time of the final settlement. Once the conditions are dealt with, the company asks the debtor to make a lump sum settlement for one of their debts for the reduced amount. And they charge a percentage of fees on the amount that the debtor saves.

Example

Let us take an example of a financially struggling debtor who cannot pay his monthly unsecured loanUnsecured LoanAn unsecured loan is a loan extended without the need for any collateral. It is supported by a borrower’s strong creditworthiness and economic stabilityread more and has no balance left in his account. The debtor has monthly earnings of $10,000, but after meeting all the necessary expenses, $5,000 is left at his disposal, which is insufficient to pay the monthly debts of $7,000.

The debtor reaches out to the debt settlement company to negotiate with the creditor for better payment terms or settle the debt by paying a lower amount. Finally, the company will advise the debtor to make a regular payment of $5,000 in a separate savings account and stop paying the creditor altogether.

After, let us say, four months, the settlement company would have collected $20,000 from the debtor. At that time, it will ask the creditor to accept the lump sum payment of $15,000 on the debtor’s behalf and settle the debt. The creditor did not receive the compensation for the last four months. Therefore, they may have written off the amount Written Off The AmountWrite off is the reduction in the value of the assets that were present in the books of accounts of the company on a particular period of time and are recorded as the accounting expense against the payment not received or the losses on the assets.read more and can accept the lump sum payment of $15,000 to settle the debt. That will forward $15,000 to the creditor and keep $5,000 as its fees.

Risks

  • This option will severely impact the debtor’s credit riskCredit RiskCredit risk is the probability of a loss owing to the borrower’s failure to repay the loan or meet debt obligations. It refers to the possibility that the lender may not receive the debt’s principal and an interest component, resulting in interrupted cash flow and increased cost of collection.read more rating, and the mark will remain for several years.The debtor will have to pay the debt settlement company high settlement fees.Even after reaching out to the settlement company, the debtor will have to continue to pay the monthly payment for a long duration.There is no guarantee of success in getting a negotiated term.

Alternatives to Debt Settlement

  • Do It Yourself: Debtors can try negotiating the settlement with creditors by offering the amount they can pay immediately, typically less than what is due.Transferring the Balance: The debtor can offer an introductory offer on a new card of 0% or lesser interest for the promotional period and transfer the balance. But they should pay the debt during the promotion period to avoid paying high interest.Non-Profit Credit Counseling: Debtors can reach out to non-profit payment counseling agencies as they do not charge hefty fees. However, they do not negotiate to reduce the debt. Instead, they arrange for better payment terms and the cessation of late payment fees.

Debt Settlement vs Debt Consolidation

  • Debt settlement is the settlement of debts by paying a lump sum amount less than the actual debt amount. The service is provided by a third party, a settlement company, against a fee, typically a percentage of the remaining debt or the saved amount.The debt consolidation option combines several debts into one and takes out a single loan with a lower interest rate and lesser monthly payment to pay the debt. Debtors avail of this option to manage their secured and unsecured debts.

Advantages

  • It saves the debtor from bankruptcy and its stigma.It helps the debtor finally pay off the debt and get creditors off their back.It lowers the total debt amount.

Disadvantages

  • It severely impacts the debtor’s credit score.These companies charge hefty fees, and thus, it can cost more to the debtors.There is no guarantee that the debt settlement company will negotiate reduced debt.There can be tax consequences for the amount not paid to the creditor under the negotiated settlement term.There is a potential risk of a lawsuit from the creditor’s side.

This article is a guide to Debt Settlement meaning. We discuss the debt settlement companies, examples, debt settlement vs debt consolidation, and its work. We also discuss risks, along with advantages and disadvantages. You can learn more about it from the following articles: –

  • Distressed DebtDebt ReliefDebt InstrumentsDebt Consolidation