How Debt Settlement Works

By Bradley Songer on October 5, 2010

Debt settlement is the method of a borrower negotiating with their creditors to decrease the overall debt they owe with a lump sum payment. A successful debt settlement transpires when the creditor agrees to decrease the borrower’s total account balance. Only unsecured debts not secured by assets like homes can be settled. Unsecured debts include medical bills and credit card debts. They exclude student loans, auto-financing or mortgages.

In order to negotiate with a Debt Settlement Company a borrower requires a lump sum of cash or the ability to build-up enough funds over a pre-determined interval of time. For borrowers who have no cash to make a lump sum settlement offer, debt settlement companies construct a third party account where funds accumulate for the settlement process. A Debt Settlement company will use an FDIC insured trust account. Once enough funds are built up the negotiation process can begin with each creditor individually.

Debt Settlement companies usually bundle their settlements into a larger bulk-settlement with the creditor for 30% - 50% of the existing balance. The debt settlement companies typically have formed a mutually beneficial relationship during their business agreements with the credit card companies/creditors and can come to a settlement agreement quicker and at a more favorable rate than an individual acting on their own behalf. With the current economic downturn, credit card companies may be willing to settle existing credit card debt balances rather than add to their already large losses of ‘bad’ debt.

Debt settlement companies do have their disadvantages, however. They usually take a percentage of the savings of the exonerated debt as the fee for their services. The failure rate of debt settlement programs’ payment plans are high because these programs tend to last between twelve and sixty months and consumers who find themselves in these sorts of debt settlement situations have difficulty paying within the structured payment program for an extended period of time. Credit card accounts normally go into collection after they are written off, typically 180 days after the last payment on the account. The debt settlement companies may not manage correspondence from the credit card companies nor the collection agencies. Individual borrowers can also be sued by creditors/credit card companies who are seeking to recover debts and interest. This can be usually be adequately avoided by using debt settlement companies with good standings and business practices that protect consumers from these often times dubious procedures.