Should You Try Debt Settlement? Here's Everything You Need to Know

Debt settlement means paying less than you owe in order to remove a debt obligation. For example, if you owe $5,000 on a credit card but can't afford to pay off the balance, the creditor or collection agency that owns the debt may agree to take a lower amount -- say, $3,000 -- with the agreement that you'll no longer owe any money after you pay.

If this sounds too good to be true, it's because there are several downsides to keep in mind. Here's a rundown of the pros and cons of debt settlement, some words of caution before you proceed with trying to settle your debts, and how to tell whether it could be a smart move for you.

Pros and cons of debt settlement

The biggest benefit of debt settlement is that you'll eliminate a financial obligation for significantly less than you owe. And even though debt settlement is a generally negative factor in your credit score, it's worth noting that a settled collection account looks significantly better than an unpaid one.

On the other hand, there are some big potential drawbacks to keep in mind:

• Most significantly, settling a debt for less than you owe can have a major negative impact on your credit score for years to come. In most cases, debts you settle can remain on your credit report for seven years.
• A record of settling debts can make it difficult to obtain a new credit card or loan.
• Negotiating a debt settlement can take a long time (years in some cases). In the meantime, the debt is still yours, as is any required payment obligation.

Debt settlement companies

It's certainly possible to negotiate debt settlements directly with your creditors, and this is especially true if you have accounts that have already been sent to collection agencies. After all, collection agencies typically have bought your debt for significantly less than you owe, so they can accept a reduced amount and still potentially make a profit.

However, there are companies that offer to renegotiate or settle your debts on your behalf. And while these can often be legitimate businesses, there are a few things to keep in mind, according to the Consumer Finance Protection Bureau (CFPB).

For one thing, these companies often charge high fees. The CFPB recommends avoiding any debt settlement company that charges fees before it settles your debts. Legally, the Federal Trade Commission (FTC) prohibits charging fees before debts can be resolved. It's also a good idea to avoid companies that promise a specific amount or percentage of debt reduction, or that guarantees to make your debts "go away."

Furthermore, many debt settlement companies encourage customers to stop paying their credit card bills while they are negotiating with your creditors. This can result in large penalties, higher credit card interest rates, and can cause even more damage to your credit score.

If you want to settle your debts for less than you owe, an alternative is to contact a nonprofit credit counseling agency, which can provide much of the same services and advice. It can work with your creditors to come up with a debt repayment plan you can afford and may even be able to lower your interest rates in some cases. Plus, nonprofit credit counseling services will only give you advice that's in your best financial interests.

Is debt settlement right for you?

Debt settlement can reduce your financial burden while helping you avoid bankruptcy, but it isn't the right move for everyone, especially if you feel overwhelmed with credit card balances that have not yet been sent to collection agencies. In these cases, it's always a smart move to talk to your creditors first and let them know your situation. You might be surprised at how receptive and willing to work with you they can be.

One important thing to keep in mind is that it is in nobody's best interest to send your debt to collections (except for the collection agency itself). So, while debt settlement is an option, it's often smart to try to work with your creditors, or to have a credit counselor do so on your behalf before you decide to settle your debts.