4 Situations When Debt Settlement is the Answer

When should you settle your debt? It's a good choice in these four situations.Image source: Getty Images.

Debt settlement is a process of negotiating with your creditors to get those creditors to agree to allow you to pay less than the total you owe on your outstanding debts.

Debt settlement usually involves making a lump sum payment for less than the full balance due on your debt and having the rest forgiven. But it could also mean negotiating a payment plan that reduces your interest rate and outstanding balance so your remaining debt is easier to pay off.

Debt settlement can provide financial relief from burdensome debt, but it will hurt your credit so the decision to settle debt shouldn’t be taken lightly. Still, while debt settlement reduces your credit score, it can also help you turn things around and start rebuilding your credit.

There are definitely times when debt settlement makes sense, including in the following four situations.

1. When you can’t make your payments on time

If you’re so overwhelmed with debt that you can’t make your monthly payments on time, this is an ideal situation to settle your debt.

Most creditors won’t agree to settle debt until you’ve been late on payments or missed payments -- so you’re well positioned to get your creditors to negotiate with you if you’ve been having trouble paying the bills. Plus, every single late payment can knock tons of points off your credit score, so your credit is already suffering when you’re paying late or missing payments.

By settling debt, you can stop the continual reporting of negative info due to those late or missed payments.

Sure, your debt will be listed as settled on your credit report and you’ll take a hit for it. But you can start applying for new credit after settling your debts -- even if that means needing to get a secured card. Then you can work on rebuilding a positive payment history once you’ve freed up some room in your budget through debt settlement.

2. When you owe more than you can reasonably pay back

There are some circumstances where you simply owe way too much money to ever feasibly pay it back. This could happen if you get way too far in credit card debt, or if you incur significant other debts, such as tax debt (that’s right -- the IRS is even willing to settle debts sometimes if you make an offer in compromise).

Typically, if you owe more than your annual salary in high-interest consumer debt such as credit cards, you’re in too deep to feasibly be able to pay back what you owe. This doesn’t mean you’re in over your head if you have a high mortgage -- this kind of low-interest debt can be paid back over time and is often considered good debt.

However, if you have payday loans, consumer credit cards, and other high-interest loans with a total balance that exceeds what you earn, you’re in serious financial trouble.

Owing such a substantial amount could mean it takes you almost your entire working life to try to climb out of debt. It will be impossible to do the things that you need to in order to prepare for your future and grow your net worth if all your extra cash is constantly going to debt repayment.

Settling your debt by paying back less than your balance or entering into a reasonable payment plan could help you to stop throwing away all your hard-earned cash on interest so you can start to do other important things with your money -- such as saving for retirement or saving for a down payment on a home.

3. When all your monthly payments are going to interest

If you’re deeply in debt and your creditors charge a very high interest rate, most or all of your monthly payment may go toward paying interest and fees. If this is the case, you could end up paying debt for decades without ever making a dent in the principal balance. This is just throwing good money after bad because each payment will enrich your creditors without improving your own financial situation.

You need to escape this cycle. If you can refinance your debt to lower your interest rate or reduce your monthly payments, that’s a better approach. When this isn’t possible, settling your debt may be the only way to actually bring your balance down to a reasonable level so you can someday become debt free.

4. When you’re considering bankruptcy

Bankruptcy is much more damaging to your credit than settling your debt is. Bankruptcy could also cause you to liquidate some of your assets if you file for protection under Chapter 7 of the bankruptcy code -- or could force you to repay some of what you owe over a three-to-five-year repayment plan if you file under Chapter 13.

Bankruptcy should be a last resort, not just because you could damage your credit and end up losing property or making payments for years, but also because bankruptcy costs money and could haunt you for a decade. So if you’re struggling so much with debt that you think bankruptcy may be the answer, you should definitely talk to your creditors first about whether they’re willing to settle debt.

Your creditors don’t want you to declare bankruptcy because then they will usually end up getting very little, if anything, of what you owe. When they believe you’re in danger of filing bankruptcy, they’re likely to be much more generous in settling debt.

Is debt settlement right for you?

If you’re in over your head and paying off your debt seems like an insurmountable goal, you don’t have to keep struggling. Work with your lender to negotiate a settlement for your debt, or consider getting help from a non-profit credit counselor or debt-settlement lawyer who can help you negotiate a settlement.

Finding a way to deal with your debt can help you get on the path towards rebuilding your credit and improving your financial situation, so don’t hesitate to act when your debts are unpayable.