5 important facts to know about debt settlement, according to experts

Getting into debt is easy and can happen in the blink of an eye. Common reasons for going into debt are paying for an unexpected expense, losing income or making poor spending choices.

If you're carrying more debt than you're comfortable with, you're not alone. According to a Northwestern Mutual study, 35% of Americans are either carrying their highest level of debt or close to it. The average level of personal debt, not including mortgages, is $21,000. 

While getting into debt is easy, getting out of debt can be challenging and even overwhelming. Debt consolidation loans, 0% APR balance transfer credit cards, credit counseling and debt management plans are options you might consider if you're facing insurmountable debt.

Debt settlement is another option to consider if you're exploring ways to manage your debt. There are a lot of misconceptions about how debt settlement works, but it's important to know the facts before proceeding so you can make an educated decision.

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5 important facts to know about debt settlement, according to experts

We reached out to debt experts to learn more about this approach. Here's what they said borrowers should know:

Settlement lowers your debt

Debt settlement is when you work with a debt relief company to resolve your debts, potentially lowering your debt by as much as 20% to 50%. These companies typically advise you to stop making debt payments and deposit it into a savings account they establish for you. Once you've built up sufficient savings, the debt relief company may negotiate with your creditors to make a lump-sum payment, usually for less than your debt amount.

"The biggest benefit of debt settlement is that it can significantly reduce the total amount of debt you owe," says Leslie Tayne, a financial attorney and author of Life & Debt. "Rather than spending years straining to keep up on debt payments, which means your other bills and financial obligations may be pushed to the wayside, debt settlement allows you to satisfy your debt once and for all."

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Settling debts could harm your credit

As you might imagine, missing payments could negatively affect your credit, as payment history is a critical factor with major credit scoring models. Missing or late payments stay on your credit report for seven years from the first overdue date.

Tayne cautions debtors there may be additional impact on their credit. "If you reach an agreement, your credit report will note 'settled in full' once you've satisfied the settlement. This is viewed less favorably than 'paid in full' and may also ding your score."

Because of the potential for damage to your credit score, debt settlement is often pursued as a last resort alternative to bankruptcy, which could severely impair your credit for up to 10 years.

Settlement may change your account terms

Still, debt settlement may provide relief for those who've been unable to climb out of overwhelming debt. "By reducing the interest rate, the principal amount, or extending the term of the loan to spread the payments out in more manageable amounts, people who fell into an unforeseen financial hardship—such as an illness or a sudden job loss—can buy time to work their way out of their debts," notes Daniel Gielchinsky, a founding partner at DGIM Law who represents debtors, creditors and other parties.

Debt settlement companies charge fees

Be aware the debt settlement process comes with costs, including fees ranging from 15% to 25% of the settled amount. Additional costs could include fees to administer the savings account used to save for settlement funds.

Also, remember the IRS considers forgiven debts as taxable income. "If substantial amounts are forgiven there will be a tax bill on that amount," says Michael Sullivan, a personal financial consultant with Take Charge America. "The actual cash benefit may not be enough to justify the impact on a consumer's credit rating."

Debt settlement may help you avoid bankruptcy

If you've exhausted your options and are still drowning in debt, pursuing debt settlement could make sense. "A consumer with an above average income and a great deal of unsecured debt might find that the risk of debt settlement is warranted," says Sullivan.

"Consumers should always seek legal advice before making bankruptcy decisions, but some may be told that a Chapter 13 bankruptcy filing could result in such a difficult repayment scenario that it would be worth trying debt settlement."

The bottom line

Consider consulting your tax accountant or financial advisor when making important financial decisions, including debt settlements. If you decide to proceed with debt relief, make sure to work with reputable companies. Read reviews on Trustpilot and the Better Business Bureau (BBB) to get a feel for how a company treats its clients. Bear in mind, legitimate debt settlement companies will never ask you for money upfront or guarantee all your debt will be forgiven.