How Does Debt Settlement Work?

“Do you owe thousands in credit card debt? We can help you reduce your debt so that you pay just pennies on the dollar!” Chances are that you have heard something similar on the radio (or seen an ad in print or online) with a similar promise. While it may seem too good to be true, many of these ads are actually advertising a legitimate service: debt settlement.

What is Debt Settlement?

Debt settlement is a process by which creditors accept an amount of money from you that is less than you owe. Rather than waiting for you to go through a payment plan where you pay off the entire debt (including interest and other accrued fees), the creditor agrees to let you pay less than you owe over time.

Your debt is considered done and over with when you settle your debt. It is possible to attempt to settle your debt on your own, but many people who go this route work with a debt settlement company that helps them.

Why Would the Creditor Accept Less Than You Owe?

Debt settlement works on the principle that the creditor is convinced that you won’t be paying the whole amount anyway, so some money is better than no money. Rather than risk being left with nothing because you just don’t pay, or even file for bankruptcy, the creditor (usually those who have made unsecured loans to you) agrees to settle with you for a lesser amount paid at once.

Of course, since the point is to convince your creditor that you won’t be able to make payments, you have to, in fact, stop making payments. Most creditors won’t consider settling until you are at least 90 days behind on your payments. When you do this on your own, you can set aside money in an account, allowing it to build up over time, while you stop making payments. When you settle debts with the help of a company, you actually make monthly payments to the service provider. The debt settlement company takes a fee off the top, and then puts your money in an account.

None of the money goes to your creditors. Instead, it grows until the creditor is ready to settle. Then, when the creditor is ready, the settlement company negotiates the amount you will pay, and uses the money from your account to pay the creditor.

Debt Settlement Will Destroy Your Credit Score

The first thing you have to understand about debt settlement is that it can harm your credit score. Obviously, since debt settlement doesn’t work unless you haven’t been making payments, your credit score will plummet because you are behind on your accounts. Next, you will receive a negative entry on your credit report regarding the settlement.

Normally, you want a loan account marked paid as agreed or paid in full. This indicates that you fulfilled the terms of the loan. If you go through debt settlement, your account will be marked as paid but it will be missing that crucial as agreed. In some cases, it might even be noted as settled. This lets future lenders know that you have settled your debts before – and that you might do so again. Some lenders are quite reluctant to let you borrow if they suspect you won’t repay the loan according to the original terms.

Bottom Line

If you are already struggling, and already behind on your debts, debt settlement might be an option. Make sure that you are working with a legitimate company with certified debt arbitrators, and that is accredited by The Association of Settlement Companies. Also, shop around for lower fees and look for a service guarantee. If you are current on your accounts, though, you should think twice before ruining your credit with a debt settlement.

Have you used a debt settlement company? How did it go? Leave your thoughts in the comments section!

This article was originally published October 3rd, 2012.

Miranda writes about personal finance almost every day. An experienced freelance writer, she's covered your money online and in print from every angle and is always looking for new ones.

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