How to Avoid 8 Common Debt Settlement Pitfalls

We all fall behind occasionally. If you find yourself owing more than you can pay back, you might be considering debt settlement, a debt relief strategy that could help you get your finances back on the right track. It has costs, though, and takes some time. Being aware of the fees and potential problems could help you decide whether debt settlement makes sense for you. 

Here are eight common debt settlement pitfalls to be aware of, and how to avoid them.

Debt Settlement Pitfall #1: Thinking Debt Settlement Is A Big Magic Wand

Solution: Focus on the right debt.

One of the biggest debt settlement pitfalls is thinking it can wipe out all your debt at once. This isn't the case. 

Debt settlement works best with unsecured debt like credit cards, personal loans, or medical bills. These are debts that aren't backed by collateral—something the creditor could take and sell if you can't make your payments. 

On the other hand, secured debts like mortgages and car loans are not a good fit for debt settlement. That's because the collateral itself—the home or the car—has value. So if you can't pay, the creditor can seize it and sell it. Collateral is a safety net for the lender. 

With unsecured debt, creditors don't have this option to get their money back. That’s why interest rates are typically higher on unsecured debt. 

If your primary goal is to deal with your unsecured debts and leave only your secured debts to manage, debt settlement could still work for you.

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Debt Settlement Pitfall #2: Believing There’s No Other Path You Can Handle

Solution: Consider other alternatives. You can do it.

One of the most costly debt settlement pitfalls you can encounter is diving in without exploring your other options. Just because debt settlement is a potential solution to your problems doesn't mean it's the only one—or the best one.

Before you decide on any strategy, consider all the ways you might get a handle on your debt, including:

• Debt consolidation: Streamline your debts, and possibly lower your costs. 

• Credit counseling: Learn budgeting or other strategies that could help you get (and stay) caught up on your debts.

• DIY debt payoff plan: Use the snowball or avalanche method to pay off your debts over time.

Weigh the pros and cons of each option before deciding which is right for you. 

Debt settlement is a big gun for serious debt problems. Given some of the other pitfalls described below, it might make sense to start with something like credit counseling first. Then, if that doesn't work for you, you can proceed to a strategy like debt settlement.

Debt Settlement Pitfall #3: Underestimating How Long Debt Settlement Takes

Solution: Get ready for the long haul.

A debt settlement program typically takes two to four years to complete. How long it takes you depends on factors like how much you owe, how much you can afford to pay each month, and how far behind you're on your payments. 

During the debt settlement process, you’ll save up money to offer your creditors. It’s hard to afford this while also making your debt payments. So most people choose to stop paying their debts while they’re in a debt settlement program. (If you stop paying your debts, your credit score is likely to suffer.) 

Your creditors will probably reach out to you during this time. They might call you or send you letters alerting you to the amount you owe, hand your debt to a collection agency, or even sue you for the debt. You might also get hit with late fees.

Debt Settlement Pitfall #4: Worrying About Your Credit Score More Than Your Wallet

Solution: Build financial stability first. Better credit naturally follows.

It's natural to worry about the effect debt settlement could have on your credit score.

You may not be concerned if some of your accounts were already in delinquency.  If your debt accounts are in collections or default, your credit score is probably already harmed. But if you currently have good credit, you might be reluctant to let it go.

It's important to stay focused on your main goal: becoming financially secure.

If your debts make it impossible to keep up with your monthly bills or save for your long-term goals, a hit to your credit might be the lesser of two evils. Once you've gotten rid of those debts, you can refocus on improving your credit and building emergency savings. Credit scores are fluid. They can and do change over time. It’s possible to rebuild good credit, even after debt settlement.

Debt Settlement Pitfall #5: Going It Alone When You’re Stressed

Solution: Get professional guidance.

Anyone can negotiate directly with their own creditors. If you have the grit and patience, go for it. 

Creditors want to get paid, so they usually play hardball if you tell them you can’t afford to pay your debts. If you’re uncomfortable negotiating on your own, or you’re overwhelmed by the process, or you just don’t have the confidence in your ability to get the best outcome, help is available.

You don’t have to go it alone.

Working with a professional debt settlement company might make the process easier and more successful. Plus, it relieves you of the burden of having to contact every single one of your creditors, likely multiple times, to make offers and negotiate terms. 

Debt Settlement Pitfall #6: Falling For A Debt Relief Scam

Solution: Choose professional debt settlement help carefully.

There are reputable debt settlement companies that can do the negotiating work for you. But there are also plenty of scammers posing as someone who can help you get out from under your debts quickly and easily. 

Before choosing a debt settlement company, research it carefully to make sure you're dealing with a reputable organization. Some things to look for are: 

• A long history in the business

• A successful track record

• Trained experts

• Membership in an industry association, such as the American Association for Debt Resolution

• Doesn’t charge fees unless a settlement is reached, you approve it, and at least one payment is made (doing so would violate federal laws)

• Doesn't make big promises about how much debt they can wipe out (there’s no guarantee)

• Doesn’t claim to prevent debt collection calls and lawsuits (they can’t)

• Doesn’t claim access to “government programs” to wipe out consumer debt (there’s no such thing)

If you come across a company that tries to charge upfront fees, promises to wipe out all your debts, or says it can eliminate your debts in just weeks, it's likely you're dealing with a scam. 

Debt Settlement Pitfall #7: Underestimating The Tax Consequences Of Debt Settlement

Solution: Consider your tax situation before you settle a debt.

Potential tax consequences are one of the debt settlement pitfalls people are least prepared for. The federal government considers forgiven debts, including debts you eliminated through debt settlement, to be taxable income. 

For example, if you owe $10,000 to a creditor who then agrees to settle your debt for $5,000, the other $5,000 could be taxable in the year the creditor forgives the debt. If you’re in the 20% tax bracket, you’d owe $1,000 in taxes on that forgiven debt.

But you may not have to pay anything, depending on your circumstances.

If you're insolvent—that is, the total value of what you owe is bigger than the total value of what you own before you settle any debts—the forgiven debt isn’t taxable. 

If you’re solvent, the government believes you could pay the taxes, and it adds the forgiven amount to your taxable income for the year. Even then, it might not result in a bill. If you normally get a large tax refund, the extra tax associated with the forgiven debt might just offset some of that. 

Consult with a tax professional before settling any debts if you're worried about an unexpected bill.

Debt Settlement Pitfall #8: Feeling Hopeless And Lost

Solution: Have a debt expert describe the plan, your options, and what to expect.

Explain your situation to a debt expert. They’ll let you know your options and what will be expected of you. This should include how they will negotiate with your creditors and what fees you will have to pay.

Dealing with debt isn’t quick or easy, and your debt settlement professional should be there to support you through the entire process. They should be your cheerleader. If they’re not, find a new one. 

Lean on your debt expert and negotiators. Their job is to help people going through a rough time. They’ve helped others just like you.

Using Debt Settlement To Get Your Finances Back On Track

Are there debt settlement pitfalls to watch for? Yes. But knowing what they are can help you avoid them.

Using debt settlement successfully can be the turning point that eventually puts your financial problems behind you.