For people struggling with debt, debt settlement seems like an easy way out of financial woes. Is this the truth? There is definitely some good that the service offers. On the other hand, it also comes with its fair share of setbacks and pitfall. So, how will a debt settlement affect your credit score? Let’s shed some light on its pros and cons.
How Does Debt Settlement work?
Debt settlement is a service offered by third-party companies (aka “Debt Collectors”) where they negotiate your debts to be paid off as lower amounts. In return, you are charged a percentage on the negotiated debt.
Pros of Debt Settlement
- Lower Single Monthly Payments
After negotiation, the monthly payment you will be making to your creditors will be much lower than before. They are able to secure better terms hence reduce your debt.
- It Saves You Money On Large Debts
Stopped payments during the negotiations make creditors desperate and willing to accept new settlement deals. Most of the deals reduce up to 50% of your original debt which saves you a lot of money. However, this lowers your credit score as lenders indicate that the amount paid was less than the agreed amount.
- They Help You Avoid Bankruptcy
This is a situation where you cannot pay your lenders. Filing for bankruptcy can lower your credit score. Debt settlement is a cost-effective way of settling your debts without declaring bankruptcy.
- It Helps You Control The Period Of The Settlement Program
You can control the period depending on your circumstances. You can decide on clearing your debt in a period extending up to 3-5 years. It depends on the savings you are able to put in your separate savings account.
- Get Creditors And Lenders Off Your Back
You consequently become less stressed as the terms and conditions are much better. This helps you avoid desperation. However, this will still worsen your score as creditors report settlements to credit bureaus.
The Cons of Debt Settlement
- Your Creditors Might Refuse To Negotiate
Some creditors don’t even accept negotiating with debt settlement companies. For those that accept, there is no assurance that you will get a settlement deal. If you had defaulted on any payment expecting a deal, your credit score will take a hit.
- Your Debt Could End Up Being Larger
If you cease making your payments during the negotiation process, you will pay accrued interest. Additionally, the forgiven portion could be considered taxable income and attract taxes. These costs could be 20% more than your original debt. Higher accrued debts show you are not good at managing your finances, bringing about detrimental consequences on your credit report.
- You May Be Charged High fees on Partially Settled Debts.
The settlement companies charge their first commissions after you have made the first repayment, after the agreement. The rest is charged on the rest of your remaining unsettled debts.
Consider this: If your total debt was $20,000, and your negotiated payment becomes $15,000. The debt settlement company may agree to settle $10,000 of the initial debt. They are allowed to charge a commission of up to 50% on the $10,000 as a fee even though you still owe $5,000 more.
- It Could Lower Your Credit Score
Debt settlement companies advise you to stop making payments for two reasons:
- To force lenders to accept their deals.
- So that you can save money and make a lump-sum payment.
But this may be at a point in which no agreement has been reached and those failed payments reflect negatively on your credit reports which will definitely lower your credit score.
The Bottom Line
A debt settler can require you to give them a large lump sum, meant for debt repayment. They can hold the funds in escrow for months or years, as they negotiate with your creditors.
This cash could have helped you instead of being held. It gets even worse, they may refuse to return it, if you had already unknowingly signed documents giving rights to it. Furthermore, if they take long without paying the lump sum, your credit score lowers as you are defaulting on payments.