Is Debt Settlement Worth It?

Debt settlement could drastically reduce the amount of money you owe, which can be a huge relief when you're in a tough situation. But it’s not a quick or easy way to get rid of debt. After you balance out the costs and benefits, is debt settlement worth it?

The right debt relief answer depends on your circumstances. Debt settlement can be worthwhile if your situation fits and you understand the risks.

Debt Settlement Is an Option for Unsecured Debt

Debt settlement is for unsecured debt, such as credit card balances and personal loans. Unsecured debt isn't backed by collateral—something of value that the lender could seize if you fail to repay the debt.

Secured debt, like mortgages and car loans, isn’t a candidate for debt settlement. Debt settlement depends on negotiating with creditors to have them accept less than the full amount owed. If you default on a loan with collateral, the lender can just take possession of the collateral and sell it to get their money back. 

It’s common for people to have a mix of secured and unsecured debt. Debt settlement can still work in that case. You simply separate the two types of debt and use debt settlement for the unsecured debts. Once the unsecured debts are settled, it could be easier to afford the payments on your secured debts. 

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Debt Settlement Works Best if You Are Insolvent

Being insolvent means the amount of your debt exceeds the value of your assets. Believe it or not, insolvency has a silver lining: It can wipe out a potential tax liability from canceled debt.

Under most circumstances, the IRS treats canceled debt as income and you’d generally have to pay taxes on the amount that was forgiven. Those taxes would reduce the financial benefit of debt settlement.

If you’re insolvent, though, you won't owe taxes on canceled debt. The IRS has a worksheet to help you figure out your situation. You can find the worksheet and more information on insolvency in IRS Publication 4681. 

Debt Settlement May Be Right if Your Credit Is Already Damaged

You could reasonably ask if debt settlement is worth it because the process can affect your credit. But often, for people considering debt settlement, the damage is already done. 

Late payments are hard on your credit score. If you owe a lot of money and have missed payments, your credit score might not have much farther to fall.

Once you settle one or more debts, you can focus on managing your other bills and paying on time every month. Debt settlement could be the first step to a stronger credit profile and a better financial future.

Debt Settlement Is an Option if You Don’t Qualify for Chapter 7

Chapter 7 bankruptcy is a way of settling debts without racking up a tax liability. In Chapter 7, a court decides how to use your assets to settle your debts. For example, if you have multiple cars, the bankruptcy court could force you to sell all but one, giving the money to your creditors. If you don’t have much in the way of assets, Chapter 7 could be a cost-effective way of settling debts.

You usually need a low income to qualify for Chapter 7. The courts say that if you have the means to pay your bills, you’ll have to file for Chapter 13 bankruptcy instead, which is a three- to five-year payment plan. 

Also, like late payments, bankruptcy has a negative impact on your credit record.

In short, you should consider Chapter 7 bankruptcy as an alternative to debt settlement. If you don’t qualify for Chapter 7 based on your income or if you don’t want a bankruptcy on your record, you may decide debt settlement is a better option.

Professional Negotiators Could Relieve Some of Your Burden

If you work with a debt settlement firm, they will do the heavy lifting. A trustworthy debt settlement company has trained experts who can:

• Help you organize your debts 

• Make the calls to your creditors 

• Negotiate the settlement 

• Handle the transfer of your money to the creditor

• Ensure the creditor stands by what they agreed to

If you’re not comfortable with the idea of negotiating, which could be a difficult process that requires multiple calls, you can hand that task off. Debt settlement companies may already have relationships with some or all of your creditors and might be able to negotiate a better deal than you could get for yourself.

You’ll probably pay a fee for their services. So deciding if debt settlement is worth it becomes a cost-benefit decision: Would you eliminate more debt than the amount of fees you’d owe? 

Keep in mind that you should never pay a fee until you get results. By law, debt settlement firms can’t charge a fee until they negotiate a settlement, you approve it, and at least one payment has been made. Only then can they charge their fee.  

The Right Debt Settlement Firm Is a Key to Success

A big factor in whether debt settlement is worth it is having the right professional to guide you through the process.

Some questions to ask when choosing a debt settlement firm:

• Have they been in business for several years?

• Do they have a successful track record with a large number of clients?

• Is their explanation of the process and costs clear and sensible?

• Are they transparent about the debt settlement industry laws that they must follow?

Understand the Costs of Debt Settlement

Debt settlement can wipe out a portion of your debt. You can decide if that reward is worthwhile once you’ve considered the costs:

• Possible late fees and interest charges: During the debt settlement process, you may choose to stop paying your creditors so you can save up funds to make settlement offers. Stopping payments could cause the amount you owe to rise. 

• Potential damage if your credit is currently fair to good: If you have decent credit at the start, it’s likely to take a major hit as you go through a debt settlement process. 

• Fees may reduce the debt settlement benefit: Consider whether the amount of debt reduced is worth the fee a professional debt settlement firm would charge. 

• Settled debts may mean you have to pay taxes unless you’re insolvent: Be sure you understand your tax situation before accepting a debt settlement solution. It’s best to talk to a qualified tax professional.

Recognizing these potential costs puts you in a stronger position to make an informed decision about debt settlement. Once you know how it works, you can be more confident that debt settlement will be the right choice for your situation.

Alternatives to Debt Settlement

If you don't think professional debt settlement is worth it for you, you have other options to get yourself out of debt.

DIY debt settlement

You can negotiate your debts directly with your creditors if you'd rather not pay a company to do this for you. A DIY approach could help you minimize your fees, but you have to be prepared for the time involved in negotiating yourself. You'll also have to budget money for debt repayment on your own each month.

Credit counseling

Credit counseling agencies are nonprofit organizations that can help you budget better in order to be able to pay down your existing debt. They can help you work with your creditors to lower your interest rates where possible and set you up with a debt management plan (DMP). In a DMP, you make regular monthly payments to the credit counseling agency, which pays your creditors on your behalf. 

The process is similar to debt settlement. The difference is, credit counseling tries to keep you from becoming delinquent on your accounts while debt settlement often requires delinquency so you can save up money for negotiations. Credit counseling has its own fees, so you'll have to weigh these when deciding whether it's the best option for you.

Cash-out refinance

Homeowners with substantial equity in their home could try a cash-out refinance to get money for debt repayment. This strategy replaces your existing mortgage with a new, larger mortgage. You use the cash difference to pay off your existing debts. Then, you make regular monthly payments on your mortgage until it's gone.

You’ll have to go through all the usual steps associated with taking out a mortgage, including having an appraisal done and paying closing costs. Make sure you understand these costs before going ahead with a cash-out refinance.

Bankruptcy

A bankruptcy filing is a formal request to a bankruptcy judge for protection from creditors. In this request, you demonstrate that you can't repay your accounts and provide a list of creditors, as well as proof of income and a list of assets. Bankruptcy is an alternative to debt settlement for those who want to erase their debts for good. It’s wise to weigh the pros and cons of bankruptcy to see if it’s the best course for your situation.