The Truth About Credit Card Debt Settlement

In general, your credit card company wants its money back — all of it. Part of your agreement when using the card is that you’ll pay back all the charges you’ve made, plus any interest and fees that you accrue.

But, in some cases, credit card issuers realize that getting everything you owe simply isn’t realistic. Or that chasing you through a collections agency or lawyer to recoup funds isn’t worth the expense.

Credit card debt is unsecured, meaning your creditors can’t take your house or car or garnish your wages without legal intervention. And creditors know if you file for bankruptcy, they might never see a penny of repayment.

If you’re experiencing significant financial hardship, you may be unable to make the payments necessary to free yourself from perpetual debt. When faced with the possibility of getting no repayment from you at all, your credit card company may be willing to negotiate with you for less than the full amount. However, settling debts for less than what you owe isn’t always a strong financial choice.

What Is Credit Card Debt Settlement?

Negotiation is where debt settlement comes in. “A debt settlement is basically an agreement that you would make with your creditor,” says Katie Bossler, a financial counselor at GreenPath Financial Wellness. “The creditor would agree to accept less than the amount owed to satisfy the debt.” She adds that debt settlement amounts generally fall in the range of 50 to 80 percent of the balance.

Here’s how one debt settlement scenario might play out. Suppose you owe $7,000 on a credit card you haven’t paid in several months. Your creditor has reported your delinquency to the credit bureaus, and your late payments now appear on your credit report and negatively impact your credit score.

However, your creditor is willing to settle the debt and agrees to a lump-sum settlement of $5,000. You pay the $5,000 in full to your creditor by the agreed-upon deadline. Your creditor, in turn, writes off the forgiven debt of $2,000 and reports to the credit bureaus that you’ve successfully settled the debt.

However, this clear-cut scenario isn’t always the reality of debt settlement.

[Read: The Best Credit Cards for Bad Credit of 2018.]

Is Debt Settlement a Scam?

Debt settlement is a legitimate financial process, but there are potential pitfalls.

One of the best things you can do is learn your rights as a consumer. For instance, many people don’t realize that you can contact credit card companies directly to negotiate your own settlement or hire a lawyer to negotiate on your behalf. Bossler adds that you should make sure you’re covered by getting settlement offers in writing before sending money.

Some people looking to settle turn to a debt settlement company, which negotiates on your behalf with your credit card companies and acts as an intermediary. Instead of dealing directly with credit card issuers, you pay the debt settlement company an agreed-upon amount every month, and the company disburses payment to your creditor after reaching a settlement agreement.

But not everyone has your best interests at heart. So it’s important to watch out for less-than-reputable businesses who prey on consumers or feed them false information. Here’s some typical bad advice:

You need a debt settlement company. Some debt settlement companies insist that you must use an intermediary. Bossler says that you may actually receive mailers directly from your creditors with offers to settle your debt with no intermediary needed.

Stop working with your creditors. Some settlement businesses dangerously advise you to stop speaking with your creditors or stop paying entirely on active accounts. But withholding payments you owe in an effort to save up for a settlement amount can backfire. Interest and penalties will accrue on your credit card account, and creditors can sue you for what you owe. Additionally, issuers will continue to send negative reports to credit bureaus.

Pay in advance for settlement assistance. Still others attempt to collect a fee from you before accepting your case or before successfully negotiating a settlement. But the Federal Trade Commission expressly forbids this practice and only allows companies to collect once they’ve actually lowered or settled your debt.

Everything will be fine now. Some guarantee upfront that they’ll knock down your debt or prevent collections calls. But no intermediary can guarantee that any of your credit card companies will negotiate your debt down to pennies on the dollar or stop contacting you.

Do your research to ensure that a settlement company’s business practices are honest and designed to offer the best outcomes for consumers. Choose from among legitimate debt settlement companies. Having a trustworthy professional on your side can be helpful if you’re nervous about negotiating credit card balances on your own, aren’t making headway in dealing with your creditor directly or need an expert who can tell you whether you’re getting a good settlement deal.

[Read: The Best Secured Credit Cards of 2018.]

The Downsides of Credit Card Debt Settlement

Sometimes debt settlement is the only way to reasonably get out of substantial debt, says Alan Nesbitt, a financial counselor at financial literacy firm Clarifi. “You are allocating your potentially scarce resources in an efficient way.”

At the same time, you may face adverse consequences when negotiating credit card debt:

High fees. The convenience of working with a debt settlement company will cost you — a lot. Fees are generally structured as a percentage of your overall debt or of the forgiven amount it has negotiated on your behalf. Don’t be surprised if a settlement company charges 15 to 25 percent of the amount of debt settled.

Worsening credit. Whether you use an intermediary or not, your credit score can take a serious hit when you agree to a debt settlement arrangement. Even though you’ve repaid the negotiated amount, the fact that you settled generally appears directly on your credit report even after the credit card account has been closed. And it stays there, dragging down your score, for up to seven years.

Surprise taxes. The IRS may get involved when you settle credit card debt. If the debt forgiven hits $600 or more, you’ll usually need to pay taxes on that sum. Nesbitt says, however, that you may be able to reduce your tax liability. If your liabilities might exceed your assets, he recommends that you review IRS Form 982 with your tax preparer to determine whether you qualify as insolvent.

Amassing the cash. Bossler says that a major roadblock for consumers is getting the cash for the settlement together by the deadline. “This is part of what’s negotiated — the amount that’s agreed upon but also how quickly those funds need to be paid,” she says. The credit card company typically wants the negotiated amount in a short period.

No guarantees. Nesbitt points out that no one has a right to debt settlement. In general, you have to show evidence of hardship or out-of-control debt.

There’s always the chance that your creditors will not be willing to negotiate with you and will demand payment in full. And with debt settlement off the table as an option, you may be forced to consider even more damaging ways of escaping your debt, including bankruptcy.

[Read: The Best Low-Interest Credit Cards of 2018.]

Alternatives to Credit Card Debt Settlement

When you’re facing tough financial circumstances or spiraling debt, you may have more options than you realize:

Let zombie debt lie. Each state has its own statute of limitations on debt collection. If you haven’t paid on a credit card account for many years and have exceeded the statute of limitations, creditors and collection agencies can’t legally require you to pay what’s colloquially known as “zombie debt.”

Accelerate debt repayment. “The single best thing you can do is more strategically pay those debts,” says Nesbitt. If you have the means to pay more than your monthly minimums, adopt a tried-and-true debt repayment plan. You’ll reduce the interest you owe on your credit card, and you’ll pull yourself out of debt even faster.

Slash your interest rate. Sometimes getting a lower interest rate on your card requires no more than a request to a customer service representative. If that doesn’t work, consider transferring high-interest debt to a lower-interest card or a new card with a zero percent promotional annual percentage rate. Or look into a debt consolidation loan, which, Nesbitt says, tends to be less damaging to your credit than a debt settlement arrangement.

Consider a hardship program. Most credit card companies offer unadvertised hardship programs that feature reduced interest rates, lower monthly payments and minimal fees. These improved terms may allow you to get on top of your debt. Keep in mind that your account may be closed as part of the hardship program, and you might see that your credit score suffers temporarily as well.

Explore a debt management program. Debt counselors working with nonprofit organizations approved by the National Foundation for Credit Counseling can be invaluable in coordinating a debt management program on your behalf. A counselor speaks with your creditors in hopes of negotiating payment terms like monthly minimums and interest rates. Then, you make a single monthly payment to the credit counseling service, and your money is distributed to your creditors according to the negotiated terms.

Unlike a debt settlement arrangement, a debt management program requires you to repay your full debt, but it may allow you more time to do it while limiting how quickly your debt is growing. As a result, debt management programs tend to have significantly less negative impact on your credit than debt settlements.

Talk with a credit counselor. A certified counselor can work with you to assess your financial circumstances, create a viable budget and discuss your options. “We review individual situations to offer personalized options for managing credit card debt,” says Bossler. She adds that debt settlement is often one of the options discussed, but it’s not always the best one.

An initial phone consultation is usually free. But be sure to ask about fees for any recommended services. And check up on the credit counseling agency to ensure that it’s a well-regarded business.

Consider bankruptcy as a last resort. In most cases, bankruptcy isn’t your best option. Nor is it a cure-all. In fact, as part of your bankruptcy filing, you may still need to make payments toward debt for a predetermined period.

A bankruptcy can sit on your credit history report for 10 years, severely damaging your creditworthiness. Still, when all else fails, a good credit counselor or financial advisor may recommend bankruptcy as a means to pull yourself out of inescapable debt and offer the opportunity to start rebuilding your financial life.

Debt settlements are worth consideration when you’re struggling with credit card debt. But it’s important to be aware of the implications of negotiated debt and avoid disreputable settlement agencies. Most important, however, is that you weigh your options carefully to ensure that the steps you take to conquer your debt are truly the best choices for you.

More from U.S. News

Everything You Need to Know About Credit Counselors

Can You Get a Credit Card Without a Credit Check?

What to Do if You Trigger a Penalty APR on Your Credit Card

The Truth About Credit Card Debt Settlement originally appeared on usnews.com