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Debt Settlement

Debt settlement occurs when a creditor and a borrower fully satisfy a debt for a reduced payoff amount. This generally happens when a debtor is unable to meet his or her debt obligations due to various financial hardships. The creditor agrees to cancel a portion of the debt and accept a negotiated sum as full repayment of the debt. For this reason, debt settlement is often referred to as debt negotiation. The settlement is the actual agreement, while the debt negotiation is the process in which an agreement is reached.

Consumers usually turn to debt settlement when experiencing legitimate financial hardships. When unable to repay their debts through debt management plans, they must find another way to avoid filing for bankruptcy. Debt settlement programs are often the answer.

These programs are provided by third-party debt resolution firms. The firm will set up payment plans and negotiate settlements for the borrower. The goal of a debt settlement program is to lower monthly payment contributions to approximately half of the typical minimum monthly credit card payment. The idea is to find a way for consumers to become debt free as quickly as possible.

The Process of Debt Settlement

A borrower can either negotiate settlements directly with creditors or enroll in a professional debt settlement plan. Regardless, the process for debt settlement remains the same. The consumer is able to save money to build up a settlement fund. Once enough money is saved to make a reasonable settlement offer, the consumer or the debt negotiator will contact each creditor. Negotiations will be for a reduced payoff amount - usually falling between 25% and 50% of the outstanding balance.

The consumer then agrees with the settlement amount and payment is arranged. Once the payment is made, the account is considered to be settled-in-full. This is different than paid-in-full when reported to the credit reporting bureaus.

The consumer then starts saving funds for negotiating with the next creditor. The process revolves around a cycle of saving up, negotiating a settlement and payment for discharge.

The Difference Between Debt Settlement and Debt Management

Debt settlement is a different process than debt management. Debt management plans are offered by the consumer credit counseling industry.

In a debt management plan, the credit counseling agency works to lower the interest rate on credit card accounts in order to lower the monthly payments. It results in an increased amount of the payment going towards the principal balanced owed. The consumer is able to pay off debts faster.

The consumer pays the credit counseling agency one payment every month. The agency then distributes the payment to each individual creditor based on the scheduled repayment plan. The process usually takes four to seven years to complete.

In debt settlement, the debt settlement company negotiates with the creditor to lower the outstanding principal balance of the debt. The company does not negotiate lower interest rates and will not distribute monthly payments to creditors. The payoff of debts through a reduced-balance settlement is arranged between the consumer and the creditor. The consumer only makes a monthly savings deposit into a settlement fund, which can be managed by a third-party payment processor.

Eligible Debt for Settlement

In most cases, only unsecured debt like credit cards can be negotiated for settlement. Secured debts, such as mortgages and auto loans, aren't eligible for negotiation because the creditor could simply repossess the item in order to make up for loss. Most debt settlement companies have a minimum requirement of at least $7,500 of debt. However, some companies will accept smaller debt obligations.

The Benefits of Debt Settlement

The consumer benefits from debt settlement in many ways. The primary function is to pay off debts without further straining the finances. The majority of consumers who enter into debt settlement are facing financial hardships caused by unemployment, loss of income, medical expenses or other burdens. The consumer is able to avoid bankruptcy through debt settlement.

The creditor benefits by helping the consumer avoid a bankruptcy situation. When a borrower enters bankruptcy, the creditor can lose funds. Debt settlement often recovers more funds for a creditor than other collection methods. For example, collection agencies will often charge a 40% commission on recovered funds.

The Disadvantages of Debt Settlement

Critics have four main objections to debt settlement:
 
1. Damaged credit reports
2. Increased collection calls
3. Probability of lawsuits
4. Tax Consequences

The consumer must save up funds in order to negotiate a settlement. However, many consumers are unable to make their minimum payments towards their credit cards when saving for settlement. This results in the credit card company entering negative reports to the three major credit bureaus.

Payment history makes up 35% of the consumer's credit score. Reports of non-payment or late payment can lower a credit score drastically, preventing future credit from being obtained.

The debt settlement industry argues that the loss of credit score is worth becoming financially stable. Maintaining a good credit score at the expense of basic needs is harmful to the consumer and family.

When debts are not repaid on time, they often enter debt collection. The process of debt collection can be quite stressful on the consumer who is unaware of his or her rights. The debt settlement industry says that most enrollees have already received collection calls by the time they enroll in a settlement plan. In fact, many companies offer assistance with collectors and educate consumers about the Fair Debt Collection Practices Act and the rights afforded by it.

Another fear associated with no longer making monthly debt payments revolves around lawsuits. Debt settlement companies acknowledge that creditors have the right to take legal action to collect on delinquent debt. However, while there are many threats, very few cases actually go to court. Debt collection lawsuits cost the creditor money, time and resources. Threats are usually used to pressure the consumer to pay the associated creditor first.

Debtors who have debts partially canceled without going through bankruptcy are required to report the canceled amount as taxable income on IRS Form 980. The IRS will consider anything over $600 of cancelled debt as taxable income. The creditor will report the amount to the IRS.

However, if the consumer is insolvent at the time of the debt forgiveness, the IRS will not require the cancelled debt to be reported. The consumer must show that his or her debts are greater than assets. The amount excluded is limited to the difference between the consumer's debts and assets. For example, if you owe $20,000 and have $12,000 in assets, you can only exclude up to $8,000 worth of forgiveness.