The Pros and Cons of Settling Your Debts

Mon, Jun 3, 2013

Financial Advice

Over the past four years we’ve unfortunately had to become familiar with the term, “short sale,” which is actually a settlement accepted by your mortgage lender. And while mortgage settlements have become a common practice over the past few years, the process of settling other debts, such as credit card debt and debts being worked by collection agencies is a much more established process.

Debt settlement works like this…you owe someone a large or not so large sum of money. For whatever reason you are unwilling or are otherwise unable to pay the creditor the entire amount. You approach the creditor or the creditor approaches you with an offer in compromise, which is a fancy way of saying that they are willing to take less than the full amount due and call it even. If you take advantage of their offer then you have “settled” the debt.


Settled in Full Versus Paid in Full

There is considerable confusion of the final status of a debt that has been settled. Some people suggest that it has been paid in full.  Others suggest that it has been settled in full. Neither is actually true.

Paid in full is reserved for consumers who did, in fact, pay the entire amount due to the creditor resulting in a fully exhausted debt, or a $0 balance. Settled in full is a contradiction of terms. Settlement, by definition, means to pay less than the full amount so a debt cannot be settled in full, ever. But, a debt can certainly be settled and left with no monies due. The appropriate and unnecessarily formal way to refer to a settled debt is that it has been settled and now has a $0 balance.


Self Help or Third Party Settlements

A settlement can be negotiated a variety of ways. Consumers can hire 3rd party debt settlement companies, that will charge a fee, to facilitate the settlement process or, they can attempt to negotiate a settlement on their own. And, there’s even a chance that the lender will reach out to the consumer and begin the settlement discussions proactively.

Using a 3rd party debt settlement company can cause some problems with your creditor.  First, the settlement company will likely instruct you to stop paying your lender and to start paying them directly. This accomplishes a couple of things. First, your payments to the debt settlement company will begin to build a war chest of money that the settlement company will eventually use to make settlement offers to your lenders. Second, some people would suggest that by not paying your lender for several months that they are getting desperate for payment and will be more flexible when considering your settlement offer.

Of course consumers can negotiate with their lenders on their own. This not only saves the cost of the debt settlement company’s fee but it also might yield as good of a settlement as would have been negotiated via a 3rd party.


Impact To Credit Reports and Credit Scores

Settlements are considered to be “major derogatory” items by all credit risk scoring systems, including FICO and VantageScores’ credit scoring models. And, when you choose to settle a debt the lender will almost certainly report that disposition to the credit bureaus, all of them. On a credit report the debt will include language such as “Settlement accepted on this account”, “Partial payment plan”, or “Settled for less than full amount.”  Regardless of how it’s reported to the credit bureaus the impact is still the same.

Just because a settlement is appearing on your credit reports doesn’t mean that it’s going to automatically have a severe negative impact to your credit scores. For example, if the debt already shows as being default on your credit reports then it is likely already having a negative impact. The fact that it is eventually updated to show as being a settled debt doesn’t add to the already negative impact.

However, if you have clean credit reports and solid credit scores and you settle a debt that is not already in default and has no late payments associated with it, then yes, the reporting of the settlement will likely result in a significant reduction in your credit scores. The length of time the settlement will be reported is seven years from the default date. Depending on what your scores were before you settled the debt; you could expect to see your scores drop over 100 points.


Settling a Collection Agency Debt

When you settle a debt with your original creditor, like a credit card issuer, you really are causing them to lose a considerable amount of money. However, when you settle a debt with a collection agency or a debt buyer you are not at all causing them to lose money. To the contrary, when you settle a debt with a collection agency they are likely making a large profit on the debt.

When collection agencies or debt buyers purchase a defaulted debt from a creditor or service provider they do so for pennies on the dollar. They are able to purchase your defaulted debt for so little because they are likely purchasing hundreds of millions of dollars of defaulted debt at one time and can command a very low “per dollar” price. When they purchase the debt they become your creditor. You no longer have a relationship with the original creditor and any payments must be made to the collection agency.

Still, this is not always bad news. If they purchased a $10,000 defaulted debt from your credit card issuer they likely did so for a few hundred dollars or less. That means even if they can collection a few thousand dollars from you they’ll make a huge profit by purchasing your debt. Clearly this means they’ll be more open to settling for considerably less than the original loan amount.

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