How to negotiate a debt settlement

The average American holds a debt balance of nearly $100,000. The good news is that there are solutions to help you get a handle on your debt. Debt consolidation, for example, allows you to borrow money to pay off your current debts. Ideally, debt consolidation leaves you with just one manageable payment towards the debt consolidation loan.

But what if debt consolidation isn’t an option? Perhaps you don’t qualify for a debt consolidation loan because your credit score is too low. This is where debt settlement could come in. Debt settlement is when borrowers negotiate debt amounts with lenders. Lenders may be willing to forgive a portion of your debt in exchange for a large lump-sum payment.

How does debt settlement work?

Debt settlement requires the borrower to negotiate a payoff with the lender.

For example, let’s say you have $10,000 in credit card debt, but the interest rates are so high you fear you might never pay off that balance. You might ask your credit card company if they will accept a $6,000 debt settlement. You would pay $6,000 to have the credit card company forgive the other $4,000.

The creditor is more likely to settle with you if you have the cash available. You might be able to negotiate a future payment instead, allowing you time to save the amount. You would also need to convince the credit card company that it’s in their best interest to accept this settlement rather than risk that you will default entirely.

The settlement should be agreed to in writing. It will likely be recorded on your credit history, which can negatively impact your credit score for the next seven years.

If you have multiple debts that feel overwhelming, you may need to negotiate with each creditor individually.

Debt settlement only applies to unsecured debt. So, mortgages, which are secured by the property, and auto loans, which are secured by the vehicle, cannot be settled. If you cannot repay a secured debt, the lender will likely foreclose or repossess the asset.

Hiring a debt settlement company vs. DIY debt settlement

If the process of settling debt with multiple creditors or debt collection agencies sounds overwhelming, you might consider hiring a debt relief company (also called a debt settlement company) to do the work for you.

You stop paying your creditors and make monthly payments to the debt relief company instead. A portion of your payments will be held in an escrow account until there is enough money for the debt settlement company to offer a lump-sum payment to the creditor(s). The other portion of your monthly payments will cover the debt settlement firm fees.

Established debt relief companies have negotiated many settlements and have relationships with major debt collection agencies and creditors. With their insider knowledge, negotiation skills and connections, they may be able to negotiate a better deal than you could by yourself.

Negotiating debt settlement on your own isn’t easy because you don’t have the experience or relationships the settlement companies do. A debt settlement expert could help you save money and get out of debt faster.

Pros and cons of debt settlement

The potential benefits of debt settlement include:

• Avoiding collections or bankruptcy: Debt settlement shouldn’t be your first choice. However, if it helps you avoid having accounts sent to collections or filing bankruptcy, it may be worth it.
• Getting out from under your debt: Excessive debt or debt with high interest rates can be mentally draining.
• Forgiven debt: If you don’t have to pay the balance in full, you can get out of the debt faster.

However, there are a few downsides to consider before proceeding with debt settlement:

• Lower credit score: The settlement could be noted on your credit report, which can drag your score down for the next seven years.
• Cash requirement: You usually need to have cash to offer the creditor. This could be an upfront payment or a future paymen. Either way, you’ll need to come up with the money.
• Tax obligations: The IRS generally considers canceled debts as taxable income. So, for example, if you have $4,000 of credit card debt forgiven, you’d need to report that amount as income on your tax return.
• Account closures: The creditor will often automatically close the account once it’s settled. This means you would no longer have access to this credit line. Closing the credit line can also add another small hit to your credit score by reducing the age of your average active credit line and overall available credit.

Steps to negotiating debt settlement

Whether you decide to negotiate a debt settlement on your own or through a debt relief company, there are six basic steps to negotiating a debt settlement.

1. Verify the debt

Before contacting creditors, you need to know exactly how much debt you owe and who the creditors are.

Your credit report doesn’t list all your debts. As of April 2023, any medical debts with an initial balance under $500 are no longer included on any U.S. credit reports. Plus, older debt past the seven to 10-year deadline could still be reported to collections.

If you can’t seem to track down an older debt, contact the creditor or look through old bills. Keep in mind that most states have a statute of limitations that dictates how long a debt collector can pursue you for overdue debt.

Create a list of your creditors and how much you currently owe each one.

2. Decide how much you can pay

Take inventory of your available funds. Total your checking accounts, savings accounts and any other cash you have available.

Then ask yourself questions. How much cash can you offer without depleting your emergency fund? Take a look at your budget. How much can you realistically save each month for a settlement?

Use these figures to come up with a proposal for each creditor. It’s generally a good idea to start with a lower offer than you’re willing to pay. This will leave room for negotiations.

If your creditor won’t accept your settlement offer, ask about a payment plan. Consider payment plans that would work for you in case the creditor offers something different from what you propose.

3. Contact the creditor

Now it’s on to the hardest part of debt settlement: calling your creditors with a debt settlement offer.

Your creditors are likelier to listen to your offer if you’re behind on payments. The creditor may be worried you will stop making payments completely. Collecting a portion of your outstanding debt is better than collecting none.

As part of your negotiations, ask your creditor to report your debt to the three credit bureaus (Equifax, Experian and TransUnion) as “paid in full” instead of “settled” or “paid as agreed.” This may help you improve your credit score faster.

Prepare for some back and forth once you present your offer. You may need several phone calls or emails before the negotiations are done.

4. Complete the deal in writing

Once you’ve reached a debt settlement agreement, send a letter to your creditor detailing the terms of the agreement. Include the settlement amount and that the creditor is accepting that amount to cover the full debt.

Confirm that this letter is approved in writing before making your payment.

5. Make your payment

Make your payment by the agreed-upon date. Send the funds to your creditor well before the due date to avoid any issues.

If you’re working with a debt settlement agency, you’ll likely make monthly payments until the agency collects enough to make the payment on your behalf. You’ll likely stop making payments to your creditors. If you negotiate for yourself, you may be able to continue making the minimum payments to avoid late fees and interest charges.

Do not provide your bank account information. It is illegal for debt collectors to deduct money from your bank account without permission. However, your bank account information gives access to your account. It could result in unscrupulous debt collectors taking more than agreed.

6. Follow up with the credit bureaus

Whatever the terms of your agreement, check your credit report after you’ve made your payment to make sure your creditor reported your payment as agreed. You can get a free copy of your credit reports from AnnualCreditReport.com.

If there is an error on your report, contact the credit bureaus to correct the mistake or use a credit repair company for help.

Alternatives to debt settlement

If debt settlement seems too extreme, consider the following alternatives:

• Debt consolidation options: If you’ve been making the minimum payments for your credit cards on time and your credit score falls in the good to excellent range, you may explore debt consolidation options. You can use a personal loan, a home equity loan or a credit card with a 0 percent introductory APR on balance transfers to pay off your debt and replace it with a more manageable loan.
• Debt management plans: With a debt management plan, a credit counselor evaluates what you’re able to afford and negotiates with your creditors for lower monthly payments, lower interest or waived fees and penalties. You make monthly payments to the credit counseling agency, which pays your creditors per the terms of the agreement.

If debt settlement isn’t enough to get your debt under control, you may need to take more drastic measures. Bankruptcy is a last resort, but it can potentially discharge debts.

The bottom line

Debt settlement is a viable alternative to bankruptcy for many people. If you’re a strong negotiator with a clear plan, you can propose debt settlements directly to your creditors. Otherwise, consider a reputable debt settlement company, potentially saving you time, stress and money. Before committing to a debt relief company, research to confirm it’s a legitimate service with satisfied customers.

While debt settlement can provide much-needed relief from debt, it can negatively affect your credit and result in an unexpected income tax increase. Weigh these consequences against the money you could save and proceed with caution.