Debt Settlement

Debt settlement is an agreement in which a creditor accepts less than the full amount owed as final payment on a debt. The borrower pays a reduced sum, often as a single lump sum, and the creditor writes off the rest. It is usually used for unsecured debts such as credit card balances, medical bills and personal loans, where the lender has no collateral to take back.

Settlement can be negotiated by the borrower directly or through a debt settlement company, sometimes called a debt relief company. It sits between paying in full and filing for bankruptcy: it can cut what is owed substantially, but it damages the borrower's credit, can create a tax bill and carries real risk if negotiations fail.

A creditor will rarely agree to take less while an account is current, because it still expects to be paid in full. Settlement offers usually become possible only once an account is seriously behind. At that stage the lender has to weigh a partial payment now against the cost and uncertainty of chasing the full balance, selling the account, or recording a charge-off.

A typical settlement through a company follows a set pattern:

• The borrower enrols one or more debts and stops paying those creditors directly.
• Each month the borrower pays into a dedicated savings account instead.
• Once enough money has built up, the company offers a creditor a lump sum, often a fraction of the balance.
• If the creditor agrees, the payment is made from the account and the debt is recorded as settled.

Programmes commonly run for two to four years. Not every creditor will negotiate, and some debts may be passed to a collection agency or taken to court while the borrower is still saving.

Debt settlement companies usually charge a fee based on either the amount of debt enrolled or the amount saved. Fees of roughly 15% to 25% of the enrolled debt are common in the United States. Combined with the reduced payment to the creditor, this can eat into much of the apparent saving.

The main risk comes from stopping payments. While the borrower saves, enrolled accounts go into delinquency and then default. Late fees and interest keep adding to the balance, collection calls increase, and a creditor can sue and seek a court judgment. If the borrower drops out part-way, which many do, they can end up owing more than when they started. In some US states, a payment or written acknowledgment can also restart the time limit for suing on an old debt, so settling very old debts needs care.

Settlement is recorded on the borrower's credit report. The missed payments that came before it are recorded too, and an account is usually marked as "settled" or "settled for less than the full balance" rather than "paid in full". Under the Fair Credit Reporting Act (FCRA), most negative entries can stay on a US credit report for up to seven years from the original delinquency. The credit score damage is usually heaviest during the months of missed payments and fades gradually after that.

In the United States, the amount a creditor forgives is generally treated as taxable income. A creditor that cancels $600 or more usually sends the borrower and the Internal Revenue Service a Form 1099-C. There are exceptions. The most important for people in financial trouble is the insolvency exclusion: if total debts exceeded total assets just before the debt was cancelled, some or all of the forgiven amount may be excluded from income. This is claimed on IRS Form 982. Debts discharged in bankruptcy are also excluded.

In the United States, the Federal Trade Commission's Telemarketing Sales Rule was amended in 2010 to cover debt relief services sold by phone. The key protections are:

• A company may not collect a fee until it has settled at least one debt and the borrower has made at least one payment under that settlement.
• Fees must be in proportion to the debts actually settled.
• Money saved in a dedicated account belongs to the borrower, must be held at an insured financial institution, and can be withdrawn at any time without penalty.
• The company must disclose how long the programme will take, what it will cost and the risks of not paying creditors.

Many US states also license or register debt settlement firms, and some cap their fees. Debt collectors that the borrower deals with along the way are covered separately by the Fair Debt Collection Practices Act (FDCPA).

Debt settlement is often confused with other forms of debt relief that work differently:

• Debt consolidation replaces several debts with a single new loan or a balance transfer. The full balance is still repaid, just on different terms.
• A debt management plan, usually arranged by a non-profit consumer credit counseling service, repays the full balance over three to five years, often with lower interest rates and waived fees agreed with creditors.
• Bankruptcy is a court process that can discharge many debts entirely, but it has its own long-lasting effect on credit and may involve giving up assets.

Other countries have their own formal versions. In England and Wales, for example, an Individual Voluntary Arrangement (IVA) is a legally binding deal to pay part of what is owed over a set period, which binds all the creditors it covers once enough of them by value approve it.

• IRS Topic 431: Canceled debt – is it taxable or not?
• Telemarketing Sales Rule (16 CFR Part 310), including the debt relief provisions