Credit Counseling vs. Debt Settlement

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The Short and Long-term Effects of Debt Settlement: What consumers can expect through the process and how long it may take to rebound

By Bruce McClary NFCC | Tuesday May 12th, 2020

Debt settlement can be very tempting. If you have debts to your name, the promise of paying them off at a steep discount (maybe even for “pennies on the dollar”) probably sounds like a dream come true. However, reality may be much more like a nightmare. Debt settlement can be a long, drawn out process without much success in the short-term. Not only that, but it can have lasting negative financial impacts for years to come. Since there are not many short-term or long-term benefits, it is probably best to consider a different solution altogether. That said, here is a closer look at what to expect if you choose to pursue debt settlement.

Short Term: Stress Goes Up, Credit Score Goes Down

First, let’s take a look at the short-term effects of debt settlement. And to do that, let’s paint the scene for how you are probably feeling if you are contemplating the idea of working with a debt settlement agency: you are behind on numerous bills, you want nothing more than peace of mind and to see a light at the end of the tunnel, and you are sick and tired of nagging phone calls from creditors and third-party debt collectors. You are not just tired of owing money and not making ends meet—you are also tired of your credit score taking a beating, and you worry about how you will rebuild your credit in the future. In short, you are stressed out!

Unfortunately, the short-term effects of debt settlement will likely make this situation even more stressful for you. Debt settlement typically requires you to miss months of payments on your debts intentionally, forcing your accounts to fall farther behind. You will be ignoring your bills and letting them pile up more and more, so that the settlement agency can use that as negotiation. Essentially, a debt settlement agency wants to make you look like you are in bad shape—they want to tell creditors that your accounts are lost causes that will never be paid off in full. This might convince some creditors, but only after an extended period of missed payments. During this time, your creditors will most likely continue attempts to collect your debts as your balances grow. You may even be at risk of legal action that could even lead to wage garnishment. This will only create a more stressful situation!

Not only will those worsening circumstances cause your financial stress increase, but your credit score will take a serious hit. The impact to your credit score may be immediate and severe. Every time you miss a payment to a creditor, beyond 30 days after the due date, that can be reported to the credit bureaus as a negative mark against you. On top of that, “Payment History” is the most heavily weighted factor in the FICO scoring model, so negative marks for missed payments can have a significant impact. This problem becomes worse when you are dealing with multiple creditors. As Experian explains, “[m]issing multiple payments in a row can be worse for your credit than missing one payment,” and “[h]aving late payments on multiple accounts can be worse than a late payment on a single account.” In other words, damage to your credit score will pile up quickly and can lead to a high number of new negative marks on your credit report.

Long-Term: Low Success Rate and High Fees

The short-term effects of debt settlement are not great. But life is a marathon, not a sprint, right? You might think, and settlement agencies certainly want you to, that the short-term sacrifices are worth it for long-term success. In the case of settlement, long-term success would mean having your debts considered paid in full even though you did not pay the full balance. “Success” would also include rebuilding your credit and being able to work toward your other financial goals. However, in most cases, debt settlement fails to achieve either of these long-term goals.

First, let’s take a look at your credit score again. Like previously mentioned, it will take a beating in the short-term, but those effects are long-lasting. The missed payments will remain on your report for seven years from the original delinquency. Seven years is a long time, and will provide opportunities to improve your score, but the negative marks that the debt settlement business model essentially requires will haunt you for a long time.

As for the settlement overall, your results may vary. You should know that very few consumers are able to settle all of their debts. In fact, more than 90 percent of consumers do not settle all their debts, which means you will probably be on the hook for some of your debts in full. The worst part of that scenario is that the unsettled accounts are left for you to deal with at a point when they are much farther past due than when you started the process. Even if you do settle some of your debts, it will take a very long time. A recent study indicated that consumers only settle 43 percent of their debts by the third year of the settlement process.

Not only is debt settlement unlikely to work quickly and unlikely to cover all your debt, but it is also expensive. You can expect to pay fees in the range of 15 to 25 percent of your enrolled debt. On top of this, forgiven debt is most likely to be considered taxable income. So, if you settle a debt, you will pay your creditor the agreed lump sum, then pay a 15 to 25 percent fee to the agency, and then pay a tax bill.

A Finish Line?

Debt settlement is a long, tough road. As soon as you start down the path, you will face obstacles and serious negative impacts to your credit score, along with the potential for lawsuits and garnishments. Even if you get over these hurdles, you are not in the clear. You should prepare for a minority of your creditors to agree to settlement. This will leave you planning to pay many of your creditors back in full. Even when settlement is successful, it will come at a cost of fees and increased tax liability.

If you want to cross the finish line in pursuit of your financial goals, you are better off avoiding debt settlement altogether. Even if you have started a settlement program, it may not be too late to make a change. Familiarize yourself with the variety of debt relief options available (download our Ultimate Debt Relief Comparison Whitepaper), and contact a credit counselor for free help as you decide the best way to move forward.

When you’re in a bind financially, of course a quick fix will sound like a great solution. But, debt settlement is actually far from a “fix” in most cases.