What is a Debt Settlement?
A debt settlement refers to an agreement reached between a creditor and a borrower in which a reduced payment from the borrower is regarded as full payment. In other words, a debt settlement is a debt reduction agreement reached between a creditor and borrower.
Understanding a Debt Settlement
A debt settlement is entered into by a borrower when they lack the capacity to pay the outstanding amount of debt to their creditors. Instead of declaring bankruptcy, the borrower may attempt to reach a debt settlement with their creditors.
In a debt settlement, the borrower may engage with a debt settlement company, who would act on the borrower’s behalf. The typical process for a debt settlement is as follows:
- The borrower explains their financial situation to a debt settlement company.
- During the process, the debt settlement company would advise the borrower to stop making payments to their creditors and instead make payments to the debt settlement company (albeit at a lower payment rate).
- The debt settlement company would put the payments made by the borrower into a savings account.
- Once the savings account’s reached a certain threshold, the debt settlement company would engage with the borrower’s creditors to negotiate a debt settlement.
- If negotiations are successful, the debt settlement company would retain a portion of the money in the savings account (it is collected as fees by the debt settlement company) and distribute the remainder to the borrower’s creditors.
A borrower is required to make monthly debt payments of $10,000 to her creditor for a period of three months. The debt payment schedule is as follows:
Due to unforeseen events, the borrower is unable to satisfy the debt payment schedule shown above – the borrower is left with $0 in her savings account but earns a monthly disposable income of $8,000.
The borrower engages with a debt settlement company, who advises the borrower to withhold debt payments to her creditor and to instead make debt payments to the debt settlement company. The debt payment schedule proposed by the company is as follows:
After three months of making payments to the debt settlement company, the debt settlement company has collected a total of $24,000 from the borrower. The debt settlement company calls the borrower’s creditor and negotiates a lump-sum debt payment of $20,000 to satisfy the previously required monthly debt payments of $10,000.
The creditor, having written off the borrower due to non-payments for three months, accepts the lump-sum payment of $20,000. As such, the debt settlement company forwards $20,000 on behalf of the borrower to the creditor to satisfy the debt. For helping the borrower settle the debt, the debt settlement company retains the remaining $4,000 as a fee.
Advantages of a Debt Settlement
1. Lowering the amount of debt outstanding
A debt settlement would lower the amount of debt outstanding. In the example above, although the borrower owed $30,000 in debt, the borrower only ended up paying $24,000.
2. Avoiding bankruptcy
A debt settlement allows the borrower to avoid bankruptcy. Depending on the country, consumer bankruptcy can last up to ten years – significantly impacting the credit score of a borrower. In addition, declaring bankruptcy can potentially impact employability.
Implications of a Debt Settlement
Although a debt settlement lowers the amount of debt outstanding and allows the borrower to avoid bankruptcy, there are significant repercussions to be considered, such as:
1. No debt settlement
There is no guarantee that the debt settlement company would be able to reach a successful settlement with the borrower’s creditors. In fact, according to the Credit Counselling Society, the success rate of for-profit debt settlement companies is less than 10%.
2. Legal action by creditors
While the borrower is making debt payments to a debt settlement company and not its creditors, creditors could pursue legal action or enlist the help of collection agencies.
3. Adverse impact on credit score
A debt settlement is noted on the borrower’s credit report and adversely impacts the credit score of the borrower.
4. Additional debt accumulation
When the borrower is not making the required debt payments to creditors, interest may accumulate on that debt. If a debt settlement falls through, the borrower will end up with more than the initial debt owed.
CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following CFI resources will be helpful: