Debt Settlement versus Debt Consolidation

People often confuse debt settlement with debt consolidation, but they are not the same thing. Debt settlement is a process where the creditor and debtor agree on a reduced cash amount that will settle the debt. Debt settlement companies contact creditors and negotiate a reduced payoff. This way, creditors will at least get some part of what they are owed and can avoid using a collections company or losing money if the debtor declares bankruptcy. Debt settlement is used for unsecured debt (like credit card debt). Creditors usually will not consider settlement unless a debtor is behind on payments by several months.

What is Required from the Consumer

If you choose debt settlement, the first step is to contact a debt settlement company and explain your financial situation, giving the company names of creditors and listing the amounts owed to them. You are given an estimate for how much your debt may be reduced by as well as an estimated monthly payment. You will then choose to stop paying creditors and send what would have been your monthly payments to your trust account. These are the funds that will be used to pay your creditors in a lump sum less than you owe.

The Role of the Debt Settlement Company

The debt settlement company puts your payments into an account until it reaches a certain balance. At that time, the company contacts your creditors and negotiates settlements based on the cash balance in your account. When a settlement amount is agreed upon, the company pays the creditor and charges you a fee for the settlement.

Risks of Using a Debt Settlement Company

You face risks if you choose to use a debt settlement company, including:

• Fraud. Disreputable companies simply take your money and disappear.
• Damage to your credit score from stopping your monthly payments and for settling for an amount less than the original amount owed.
• Lawsuits. Some creditors immediately file suit when they are contacted by a debt settlement company.
• Tax problems. The difference between the settlement amount and the original amount owed is considered taxable income by the Internal Revenue Service, so you could end up with a big tax bill.

Alternatives to Using a Debt Settlement Company

Debt settlement is not the only way to deal with excessive debts. Three main alternatives are:

• Credit counseling. This creates a debt management plan between you and your creditors. If you pay on time each month, credit counseling won't hurt your credit score.
• Working out your own settlement with creditors. Some creditors have a hardship program where they will reduce monthly payments or interest rates.
• Filing bankruptcy. Most bankruptcies today result in a five-year plan for repayment of debt. It temporarily hurts your credit score, but does give you a fresh start.

Is Debt Settlement Right for You?

If you are up-to-date on your accounts, even if you're only making minimum payments, then debt settlement is not for you, and the better debt settlement companies won't accept you as a client. However, if your only alternative is bankruptcy, then it may be worthwhile to talk to multiple debt settlement companies and compare their debt settlement programs to see if one might be helpful for you.

Sources:

http://money.msn.com/credit-and-debt/when-debt-settlement-makes-sense-weston.aspx
http://credit.about.com/od/debtmanagementsolutions/qt/debtsettlement.htm
http://www.fivecentnickel.com/2009/11/30/what-is-debt-settlement/