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Debt

How Does Debt Settlement Work?

If you’ve been around for more than five minutes, you know we hate debt. You might think “hate” is a strong word, but that’s exactly how we feel about it. Debt steals from your future and keeps you stuck in your past. Yep—when your medical bills, credit card statements and overdraft fees pile up, it’s hard to think about the future, much less know how you’re ever going to make your monthly payments on time. Many people have turned to debt settlement companies to help them claw their way out. But is that really the best option?

What Is Debt Settlement?

Debt settlement is the process of using a third party to settle your debts on your behalf. If you hire a settlement company, they’ll negotiate with your creditors in the hopes that they’ll settle for less than what you owe. Most often, you’ll pay a lump sum that’s just a fraction of your original balance . . . plus a fee, of course. That’s why we say if you’re looking for debt help, you need to look elsewhere.

How Does Debt Settlement Work? 

Let’s talk about how debt settlement actually works. If you’re buried under student loans (hi there, Sallie Mae), credit card debt, and even past-due medical bills, you might feel like you’re in over your head—as any human would—especially when you’ve got debt collectors hounding you day after day. So, maybe you look for debt relief through a debt settlement company.

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Craig at Settle Your Debts LLC tells you he’ll negotiate with your creditors so you don’t have to. What a relief, right? It sure seems that way, but Craig isn’t just doing this out of the kindness of his heart. Craig tells you to stop paying on your accounts and start sending that cash to him instead. (That means your late fees and interest are adding up while you wait for Craig to do his thing.) And not only that, he also slaps a 20–25% fee on top of what you already owe. Not cool, Craig!

Let’s say you have $50,000 in student loans, $8,000 in medical debt and $5,000 in credit card debt for a grand total of $63,000. Craig does his part and charms your creditors to knock $13,000 off your debts, meaning you need to pay a lump sum of $50,000. But don’t forget, you still owe him 25% of your original debt ($15,750). When it’s all said and done, you’ll be paying $2,750 more than your original balance! And that’s if he’s not scamming you. Oh, and depending on how much you settled for, you’ll have to pay taxes on it too.1 Ouch.

Many debt settlement companies out there claim to help you with your debt—but what they’re really doing is collecting your hard-earned money (plus a fee), not negotiating with your creditors, and letting your debts rack up even more late fees and interest. We don’t say this to scare you. It’s important for you to know debt settlement companies aren’t always the knights in shining armor they make themselves out to be.

But in the event that a debt settlement company actually does what it says, your debt settlement manager will negotiate a lump-sum payment for you. Then, you’ll get on a payment plan (usually 36 months long) and deposit your payment into a savings account every month.2 But here’s the thing: Missing just one of these deposits might boot you from the program. Not only that, there’s no guarantee your creditors will agree to a settlement at all.3

Debt Settlement vs. Debt Management

Any Google search for debt help will land you smack-dab in the middle of more debt settlement options than you can handle. You might also see the term “debt management” more than you can count too. So . . . what exactly is the difference between the two?

Like we said, debt settlement is when you pay a third party to settle (or negotiate) your debts to a lower amount for a fee. Most often, you’ll save up your money over a period of time to pay this company one lump sum. Then, they’ll pay your creditors on your behalf.

Debt management is when you work with a credit counselor to create a debt management plan. This person works with your creditors to lower your interest rates and negotiate a payment plan that works for everyone. Before you get too excited, working with a credit counselor also involves setup and monthly maintenance fees you wouldn’t have to pay if you tackled the debts yourself.

Under a debt management plan, a credit counselor helps you create a plan to pay back your debts in three to five years. If you miss even one payment, you could get booted from the program. And here’s the other thing: Only certain types of debts qualify (like unsecured debts). That includes credit card debt, personal loans, medical debt, payday loans and even income tax debt. If your debt doesn’t fall into the unsecured category, a debt management plan won’t even be an option for you.

Is Debt Settlement a Good Idea?

Nope. If you’re considering debt settlement as the best way to take care of your debt once and for all—think again. Not only is debt settlement something you can take care of yourself, but it’s also often a scam. Many “debt settlement” companies accept your money only to leave you high and dry, worse off than you were before.

And like we said, paying a middleman to do something you can do yourself just doesn’t make sense. Why take the chance on someone taking your money and heading for the hills when you can call your creditors one by one and negotiate lower balances yourself?

We get it: Being up to your eyeballs in debt is scary. Living paycheck to paycheck gets old fast. And watching your bills pile up day after day is defeating. But you have the power to do something about it! Don’t let your debt control you another minute. Take a deep breath, and let’s talk about how to pay off your debt and take control of your money once and for all.

How to Settle Debt the Right Way

Are you sick and tired of being sick and tired? It’s time to take a long, hard look in the mirror and decide to do something different. Decide to change your money habits. Decide to stop going into debt for things you can’t afford. Decide right now to change. This moment could be the turning point that leads you to freedom from debt forever.

You’re probably thinking, Yes! I’m in! But how in the world do I do that? Let’s start with the next right step: choosing to settle your debts the right way.

How to Settle Medical Debts

If you’ve got medical debt to pay but you’re not in collections yet, the first thing to do is give your creditor a call. Talk to them about where you are financially and let them know you’re not able to pay your bill. They’ll try to work with you on a payment plan so you can eventually wipe out that medical debt.

If the debt is in collections, you’ll need to settle the debt with your debt collector personally. They know any payment is better than no payment at all. Without sharing too much information, let them know you want to pay your bill, but you’re not able to pay the full amount. This is where the negotiations begin. Keep negotiating (and don’t back down) until you both reach a number you’re able to pay and they’re willing to accept. Usually, that’s about 48% of the principal balance.4 And then, get it in writing!

Just remember: When you start settling debts, your credit might take a hit. Any time you get a debt balance to zero (settling the debt or paying it in full), that affects your credit. But don’t be so focused on this. When you’re on a mission to live without a credit score, that number becomes a lot less important!

How to Settle Credit Card Debt

Credit card debt can be a real beast. And since credit card companies spend fat cash on advertising each year to entice people to spend on credit, it’s no wonder so many people are carrying around thousands of dollars in credit card debt. If that’s you and you’ve reached the point where you can’t make your payments, it’s time to give your account holder a call before late payments, fees and interest swallow you whole.

Call your creditor and let them know you’re unable to afford your monthly payments now. Try to negotiate a lump-sum deal. If your credit card balance is $8,000, put your best negotiation pants on and offer to pay 40% or $3,200—if you can pay that. Your creditor will definitely go back and forth with you until you both reach a number you’re happy with.

But if a large lump-sum payment is out of reach, try a pro rata or fair share plan, giving each debt its fair share of the money you have . . . after covering your Four Walls, of course. Remember: If you’re not able to feed your family or pay your rent/mortgage, then you definitely can’t pay MasterCard.

We’ve said it before, and we’ll say it again: Once you land on an agreement with your creditor, always get the deal in writing.

How to Settle Debt in Collections

According to the Consumer Financial Protection Bureau, one in four people with a credit report had at least one debt in collections.5 If that’s you, don’t lose hope! Sure, debt collectors can be the absolute worst. And when they’re hounding you, it may not seem like they’re playing by any rules. But there are some laws they have to follow through the Fair Debt Collection Practices Act. That means you don’t have to put up with their shenanigans . . . all the time.

If your debt is in collections, follow these steps:

1. Make sure your Four Walls are covered.

You can’t take care of your debts if your family is going hungry.

2. Know exactly what you owe—to the penny.

Debt collectors aren’t known for telling the truth, especially when it comes to what you owe.

3. Start negotiating.

Any money you have left after covering your Four Walls is up for negotiation, even if it’s just $10. Anything will help. And then the golden rule: Get it in writing before you send over a single penny.

4. Start plowing through your debt snowball.

The debt snowball is the proven method to get out of debt. By attacking your debts smallest to largest, you’ll see progress in no time. And as you pay off each debt, that minimum payment will get rolled into the next, creating a bigger and bigger snowball . . . all the way to debt-free.

Debt settlement through a third party is not the way to go. If you really want to settle your debts, you can do it yourself. With an easy-to-use budget (we love EveryDollar), hard work and a lot of negotiating, you can find freedom from all that stress in no time.

But don’t just negotiate those debts. Keep working the debt snowball until all your debts are completely gone! If you’re ready to say goodbye to your debt for good, check out Financial Peace University. In nine lessons, you’ll learn how to beat debt, save for emergencies, and change your future. 

When you work the debt snowball, the debt snowball works. You can do this!

Ramsey Solutions

About the author

Ramsey Solutions

Ramsey Solutions has been committed to helping people regain control of their money, build wealth, grow their leadership skills, and enhance their lives through personal development since 1992. Millions of people have used our financial advice through 22 books (including 12 national bestsellers) published by Ramsey Press, as well as two syndicated radio shows and 10 podcasts, which have over 17 million weekly listeners. Learn More.

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