How Should I Respond to a Debt Settlement Offer?

Getting a debt settlement offer may feel like a lifeline if you’re drowning in unpaid bills. But if you settle for less than what you owe — perhaps much less — there are serious downsides, too. You may need to make an immediate payment in full and could face tax consequences. That’s why experts often recommend it as a last resort. Here’s what you should know if you’re considering a debt settlement offer.

What Is a Debt Settlement Offer?

If you have a large amount of outstanding debt with a creditor or collection agency, you might receive an offer to settle that debt.

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Debt settlement is a form of debt relief where a creditor offers to reduce the principal amount you owe on your debt, according to Kevin Gallegos, senior vice president of new client enrollment and Phoenix operations with Freedom Financial, a debt settlement company.

Sometimes you can contact your creditor and request to settle. However, it’s possible to receive an offer without asking. This usually happens after you’ve missed many payments and it’s become clear you can’t afford to pay the balance, though the exact timeline varies by creditor.

John Ulzheimer, a credit expert who formerly worked at FICO and Equifax, says, “When (the creditor) concludes that it’s unlikely you’re going to pay in full, then their next step is to collect as much as they can to mitigate their losses.”

In fact, according to Gallegos, creditors routinely settle accounts for less than the amount owed. However, he notes that debt settlement is not for everyone or every situation.

Ashley Morgan, a bankruptcy attorney in northern Virginia, says, “I never encourage my clients to become delinquent with their debt, but if you do end up delinquent, you likely will get better settlement offers.” In other words, your creditors are less likely to settle if they believe you can afford your payments. Missing payments and becoming delinquent on the account is more likely to prompt a settlement offer, though your credit will also be damaged if this happens.

How to Evaluate a Debt Settlement Offer

Ulzheimer says there is no rulebook that defines what makes a good debt settlement offer. “If you’re happy with their offer, and you should be because it’s less than what you actually owe them, then you should at least consider it,” he says. The alternative, according to Ulzheimer, is the creditor either outsourcing the debt to a collector or even suing you.

Even so, Morgan says in her experience, a settlement that requires you to pay between 40 and 60 percent of the debt is good. Often, the settlement amount depends on how likely the creditor believes that it will be able to recover the money, she says.

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Since debt settlement is a binding contract, it’s a good idea to read the terms carefully and have a lawyer review it before signing the dotted line. You should be prepared to pay the settlement right away, according to the terms you agree upon. No matter what, “Getting all agreements in writing is an important part of the settlement,” Morgan says. “The last thing you want is a misunderstanding about the situation.”

Can You Negotiate Your Debt Settlement Offer?

Just because you received an offer to settle your debt doesn’t mean you have to accept it. “You can certainly always ask for a better deal,” says Ulzheimer. “Whether you’ll get it or not is another story.” Alternatively, if you can’t settle for less, a creditor might instead be willing to report the debt as “paid in full,” rather than “settled,” in exchange for you accepting the offer.

If you decide to negotiate, you should do plenty of research first to understand everything from collection cycles to tax implications, says Gallegos. Be prepared to discuss your financial hardship and perhaps provide documentation, and conduct everything in writing, he says.

Is Debt Settlement Ever a Good Idea?

While debt settlement allows the borrower to get out from underneath a larger debt without paying it in full, there’s a major caveat: “One thing people do not usually realize is that a debt settlement can lead to a taxable event,” says Morgan.

Forgiven debt is often considered income. So if a settlement forgives $600 or more of your debt, the creditor should issue a Form 1099-C, and you must be report that as income on your taxes. For example, if a $5,000 debt is settled for $3,000, you’d receive a 1099-C for $2,000, which would count toward your taxable income for the year. “The only way to avoid this taxation issue is to prove insolvency on your taxes or file bankruptcy,” says Morgan.

Debt settlement can also be detrimental to your credit. A debt that’s reported to the credit bureaus as settled for less than the original amount could be almost as impactful as having a bankruptcy on your record. However, it’s still better than having an account reported as unpaid. And if you’ve reached the point that you’ve been offered a settlement, you’ve likely already done significant damage to your credit score.

Alternatives to Debt Settlement

For these reasons, you might want to pursue another option besides debt settlement, if you can.

Pay the debt in full. If you can pay down your outstanding debt in full, that’s usually the best thing to do. Gallegos says there are two effective debt repayment strategies you can follow:

Debt avalanche method: This strategy has you making minimum payments on each debt and putting any extra toward the debt with the highest interest rate. “Repeat this process every month until that debt with the highest rate is paid off,” Gallegos says. Once it’s paid, follow the same process for the debt with the next-highest interest rate, rolling what you were paying on the previous debt into your monthly payment. Keep following this program until all debt is paid off.

Debt snowball method: With this debt repayment strategy, you target the smallest balance first while making the minimum payment on everything else. After that debt is paid off, continue paying the minimum on all debts and put the remaining funds toward the second-smallest debt. “Many people are more successful with this method because of the satisfaction they get by eliminating entire debts, one at a time,” says Gallegos.

Take out a debt consolidation loan. If you have high interest rates, it can be helpful to consolidate credit card or loan debt into a single loan at a lower interest rate. You’ll be able to allocate more of your budget toward the principal balance on your debt rather than interest. Plus, you’ll only have one monthly payment to worry about.

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Seek credit counseling. Another option is to use an accredited credit counselor to create a debt management plan, often referred to as a DMP. With a DMP, a credit counselor will work with you and your creditors to come up with a reasonable payment schedule. A DMP helps you get your finances organized and allows the credit counseling agency to make debt payments on your behalf. While some introductory credit counseling services may be free, a DMP often requires a fee.

File for bankruptcy. Finally, if your debt load is so large that it’s impossible to pay off, you might consider filing for bankruptcy. “With Chapter 7, a lot of debt is wiped away,” Morgan says. “With a Chapter 13, a court-ordered payment plan is put into place.”

Debt settlement can work for some people, but at the end of the day, it depends on your financial situation, Morgan says. “The biggest problem with debt settlement is that you are at the mercy of the creditor,” she says. “If they do not accept your offer, there is not much you can do.”

That’s why if you can pursue another option that keeps your finances under control and your credit intact — and, ideally, allows you to pay off your debt in full — you should choose that over settling.

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