When you can't pay your bills and don't expect to be able to do so any time soon, settling the debt -- working out an agreement with the lender to pay a reduced balance or structure a payment plan -- may be an option worth considering. Though it's nothing they shout about, banks routinely wipe debt balances from their books, including consumer loans.
Debt settlement isn't an action to take lightly. A settlement shows up on your credit report as a black mark that lingers for seven years and can influence your ability to obtain new credit or a loan, and at what rate. It might be too drastic a move for consumers who could dig out with a tighter budget. Settling might not be drastic enough, on the other hand, for consumers in very bad financial shape and few assets. Filing for bankruptcy protection is also an option.
Explore alternate avenues. Before settling on a settlement, make sure you've exhausted other ways to make paying off debts more manageable.
- Control finances. Use free tools like Mint.com or Billshrink.com to see if you might be able to squeeze any extra cash out of your budget.
- Earn more. Easier said than done, but possible. Consider taking on a part-time job -- Snagajob.com lists hourly gigs -- or pulling in more cash by selling un-needed household goods on eBay.
- Consult a counselor. A debt-management counselor can help you arrange payment plans with creditors, for free or a small fee. They can also help you decide whether bankruptcy or debt settlement is the better option for a dire financial situation. Use the Federal Trade Commission's guide to find a reputable firm near you.
Build your case. You can work directly with your lender or debt collection agency to reach a settlement, which means there's no need to pay a third-party company exorbitant fees to arrange one for you. But you must prepare before calling to negotiate.
- Gather financial documents. Securing a settlement requires showing that you can't pay the full amount owed. Make a list of living expenses, income and debt obligations.
- Show life changes. Be prepared to talk about what has changed with your financial situation since you first took the loan or opened the credit card -- loss of a job, for example, or medical troubles. Have documentation on hand to support your case.
- Save settlement offers. Lenders often mail or call with settlement offers. Obtaining a deal is usually as simple as calling to say you'd like to accept it. The Federal Trade Commission (FTC) offers guidelines to handle debt collectors while you're figuring out what to do.
Strategize settlements. With limited repayment resources, which creditors you settle with and when can have a big impact on how you fare.
- Start with your least manageable debt. Creditors want to be first in line to settle, because it increases their chances of getting paid at all. Reach out to the lender whose debt carries the least-affordable terms -- either the biggest monthly payment or the highest interest rate.
- Focus on payments. Settlements typically require a lump-sum payment for the balance owed shortly after you finalize terms. Don't settle for an amount that you can't afford to pay off quickly.Use our calculator to figure out the cost of various debts.
- Consider the tax implications. If more than $600 in debt is forgiven, that amount may be considered "income" taxable at your regular rate. The IRS will send you a Form 1099-C in the mail for inclusion with next year's return. Factor that bill in when deciding whether or not to settle.
What not to do. Creditors aren't required to accept a settlement offer, and mistakes like these may make them balk.
- Don't stretch the truth. Make no mistake your creditor has a good deal of information about your financial situation already. Lying about your ability to repay won't fly, and could lead to less generous terms if a settlement is approved at all.
- Don't avoid the issue. You can only dodge creditor and debt collector calls for so long. Failing to respond could result in more aggressive pursuit or even a court summons. That could cost you more in attorney's fees or lead to settlement terms less in your favor.
- Don't deliberately skip payments. Many lenders are reluctant to settle unless you've missed several months' payments, but deliberately skipping them to spur an offer is likely to backfire. Reach out for help as soon as you begin having trouble.
- Don't fall for a settlement scam. The FTC warns that for-profit firms often promise more than they can deliver and charge exorbitant fees while your debt piles up.
For more to read: 5 Tips for Paying Down Credit Card Debt; Choosing the Debts to Pay Off Now (and Later); Limiting Psychological Damage From Collections; Should you Borrow From Your 401(k) or 403(b)?; Federal Trade Commission: Choosing a Credit Counselor; Federal Trade Commission: Knee Deep in Debt; Information from Center for Responsible Lending.