How to Settle Your Debts for Less Than You Owe:

How to Settle Your Debts for Less Than You Owe:
You Can Hire a Company - or, Better Yet, Do it Yourself!

Richard Fonfrias, J.D.
Chicago’s Financial Rescue & Bankruptcy Lawyer
Fonfrias Law Group, LLC


One way you can improve your financial situation is to persuade creditors to erase or settle your debt for an amount that’s less than the full balance you owe. You may have seen ads for companies that offer debt settlement services.

At the same time, some bankruptcy lawyers offer to settle debts for you. But you don’t need a lawyer to negotiate with a creditor. In fact, you can do it yourself and, in many cases, be just as effective as an attorney.

You might be surprised how eager creditors can be to settle debts. The further you are behind in your payments, the more willing creditors are to work with you because getting something from you is better than getting nothing.

Here’s where to start:

STEP #1: Learn the downside.
Settling debts is not as rosy as you might think. Often, here’s what you need to know before you move forward.

1. You may have better options than settling your debts.
People who work for debt settlement companies work on commission. They need to rope in as many debtors as possible, so don’t expect them to tell you the truth.

2. Bankruptcy may be a much better choice for you.
The option to file bankruptcy and get a fresh start was so important to the founding fathers that they included your right to file bankruptcy in the U.S. Constitution.

First, you work with a bankruptcy attorney, who knows the creditor/debtor system and how to protect your legal rights. In addition, either of two types of bankruptcy may be suitable for you. In Chapter 7, most of your unsecured debts (such as credit cards) are erased and you might have to sell some assets to satisfy debts. In Chapter 13, your lawyer designs a three to five-year payment schedule to satisfy your debts with creditors. Amounts remaining after five years are usually written off.

3. Your credit scores will plummet.
In most cases, if you want to settle your debts, you are very late paying your credit accounts. In this case, your credit rating has already taken a nosedive. When you settle an account for less than the full amount you owe, the creditor reports to the credit bureau that your account was “settled”, which knocks your score down even farther.

4. Lawsuits might be in your future.
When you file for bankruptcy, the bankruptcy court issues an immediate and automatic “stay”, which forbids creditors from trying to collect money from you. Not true when you’re trying to settle a debt. At the same time that you’re negotiating with your creditors, they will continue to use methods to get you to pay – including filing a lawsuit against you to encourage you to pay the amount in full.

5. You owe the IRS taxes on the amount you save.
Yes, IRS gets into the act even when you settle your debts. Any amount by which a creditor reduces your debt over $600 is taxable. So if you owe a creditor $2,000, and the creditor agrees to settle your account for $1,000, you will owe taxes to the IRS on $400.

STEP #2: Arm yourself with these answers to key questions.

What can a creditor do if you don’t pay a debt?
A creditor can file a lawsuit against you and win a court judgment against you. Once the creditor has a judgment, the creditor may garnish part of your wages and have the sheriff seize your assets.

What is the statute of limitations in your state?
This is the amount of time creditors may come after you for payment. If the statute of limitations has passed, then you have no legal obligation to pay the debt and creditors may not file a lawsuit against you to enforce payment. However, some creditors will continue collection efforts hoping that you’ll pay the bill, even though the legal deadline has passed.

How long can a debt remain on your credit report?
If a debt has not been paid for seven years, then it usually disappears from your credit report. If it’s still on your credit report, then send a letter to the credit reporting agency and ask that it be removed.

Note: Even if the statute of limitations has passed, an unpaid debt can remain on your credit report for seven years. The statute of limitations and the credit reporting time are not connected.

Will a bank or financial institution sue you because of your credit card debt?
Probably not. Banks make a tremendous amount of money from credit card interest, late fees, over-limit fees and other charges. Most banks will not waste their time or money pursuing you for payment. Even so, the more money you owe, the more likely it is that the bank will sue you. So don’t assume you’re home free.

If a bank gets a judgment against you, you risk the bank garnishing your wages or seizing some of your property or assets. That’s why it’s important that you weigh the risks of a judgment, garnishment or seizure against the likelihood of a banking taking these actions.

Has the creditor already written off your debt?
This is called a charge-off. If the creditor has charged off your debt, then you gain nothing by paying it unless it will help improve your credit rating.

Make sure you know whether the creditor or the collection agency is reporting your debt to the credit reporting agency. Once you find out, then negotiate only with the one who actually does the reporting. In this way, you can work to negotiate an outcome that improves your credit score.

STEP #3: Before you decide, consider these 6 facts.

FACT #1: Unsecured debts only. You can reach settlements only on unsecured debts. These include credit cards, department store accounts, hospital and doctor bills, and so on. Secured debts – such as mortgages, alimony and child support – must be handled in different ways.

FACT #2: Different approaches. You need to approach banks and other financial institutions differently from the way you approach collection agencies. They will not respond in the same way.

FACT #3: Lawsuit threats. You can expect them to threaten to sue you. In most cases, they’re bluffing. You’re in the strongest position when you know how this particular creditor handles collections. The creditor may be trying to scare you. Or the creditor may actually file a lawsuit.

FACT #4: Debt ownership. Credit card companies often sell past-due accounts to companies that purchase debts. Then the new company may try to enforce payment. Or, it may turn your account over to a collection agency. If you reach a settlement, make sure the papers you sign are accurate and that they state which company owns your debt. You don’t want a different company to come after you for the remaining balance.

FACT #5: Lien or judgment. In some cases, you can settle a debt with a credit card company even if it already has a lien or judgment against you. You need to make sure that the proper papers are filed with the court after you finalize the settlement.

FACT #6: Income tax. Yes, believe it or not, you really do have to pay income tax on the amount of the debt that the creditor wrote off. The IRS considers the written-off amount as income.

Each creditor who agrees to settle a debt with you will send you a 1099 form to file with your income tax return. It will tell you how much money you have to report as income on your tax return. In most cases, the amount will be the difference between the principal amount you owed and the amount you actually paid. Depending on your agreement with the creditor, the amount may include interest.

STEP #4: Decide whether to hire a debt settlement service — or do the work yourself.

Consider four key facts about debt settlement companies.

FACT #1: Sky-high fees.
When you hire a debt settlement company, you may be in for a big surprise. They often avoid telling you straight out what their fees are. In truth, it may be a real adventure just getting them to tell you what they charge.

Some companies camouflage their fees as 15 to 20 percent of your total debt, which you pay in advance. Or they may charge 25% of the amount your debt was reduced. And they may charge you a fee that I call a signing bonus, like professional athletes receive, just for agreeing to work with you.

In addition, the company may try to charge you a consultation fee, an application fee, or an enrollment fee. You can tell that these are simply ways to take more money from you. And if you can’t afford all the fees – or are not inclined to pay them – ask if they will waive the fees or allow you to pay them over a few months.

FACT #2: Vague services.
What did the debt settlement company offer to do for you? And what are they actually doing? True, they’re supposed to negotiate with creditors to get your debts reduced, but do they really do this?

After you hire a debt settlement company, they usually tell you to stop paying on your accounts. This feels really good to you because those credit card and charge accounts have been sucking you dry. In most cases, when the company receives your monthly payments, those payments go into the company’s “escrow account”, from which the debt settlement company takes its fees.

You may think that the company is settling one account after another, but in truth the company may not have settled anything.

Debt settlement companies also offer to deal with collections agencies, rather than your receiving those calls directly. But when you hire a debt settlement company, the creditor often expedites its own collection process and sends your account to collection sooner than it otherwise would.

And, if the creditor makes a practice of filing lawsuits to collect its accounts, it may sue you sooner knowing that you have hired a debt settlement company. What’s more, if the creditor files suit, the debt settlement company stops providing services (if any) because it is not a law firm, it cannot offer legal advice, and it cannot represent you at trial.

FACT #3: Lots of dropouts.
Many consumers who hire debt settlement companies drop out of the program, often because they have paid and continuing to pay the company a huge amount of money that they could have used to pay their debt. Bankruptcy lawyers hear the horror stories time and again about consumers who thought their problems would be over when they hired a debt settlement company. When, in fact, their problems were just beginning – and no debts ever got settled.

FACT #4: Operating illegally.
Several states do not allow for-profit debt settlement companies to work there. So before you hire a company to help with your creditors, check to make sure the company can legally operate in your state. In fact, many companies violate those laws, which tells you all you need to know about the company you’re thinking about hiring.

If you decide to hire a debt settlement company – here’s how to start:

1. Get credit counseling from a credible, reliable source.
Before you decide whether to hire someone to settle your debts, you should consult with a qualified, experienced credit counselor. Your counselor will help you prepare a budget and review you options, which include doing the work yourself, getting a debt-consolidation loan, and other options. If it’s wise to hire a debt settlement company, then…

2. Ask (who?) for a referral to a licensed, accredited, non-profit debt settlement company.
Then make sure they are (1) licensed to do business in your state, (2) accredited by a recognized accrediting organization, and (3) non-profit, as opposed to a for-profit company. Warning: Even when you follow these steps, you still need to research the company or agency. And if you fail to carefully review the companies you’re considering, then you could easily become the victim of fraudulent and deceptive practices, which could cost you a fortune!

3. Ask what the company offers as its “program”.
Debt settlement companies often offer services including debt management, debt consolidation, and debt negotiation. The company may not clearly disclose which of these services it provides. So make sure you ask.

4. Ask for a written quotation for the company’s services
– but only after the counselor reviews in detail your financial situation and statements. You need to know the amount of your monthly payments and how long the company needs to provide services.

5. Ask how soon the company will pay your creditors after they receive your monthly check.
Make sure the company agrees to make payments to your creditors on time and within your creditors’ billing cycle. If they send a late payment, it will go against your credit history. Ask how you can track the company’s payment and make sure you receive a monthly statement to monitor the company’s services on your behalf. Warning: Make sure you keep paying your creditors while you’re deciding whether to hire a service and enroll in their debt management program. Your creditors may not agree to work with the agency if you miss payments and incur more penalties, late charges and interest.

6. Ask how the company will safeguard your personal information.
After all, the debt settlement company will have all your financial information, account numbers, and other sensitive data. Make sure their privacy policy includes not selling or disclosing any of your information to any other person or company, except for the creditors included in your plan.

7. Don’t agree to the debt settlement plan unless you know you can make the monthly payments.
If the amount is too high, ask if they can lower the fee or suggest another option so you can afford their services.

8. Make sure you read the contract, including all the terms and conditions, so you know what they promise to do – and what they require from you. Make sure everything they have promised to do for you is also written into their contract. Also, pay close attention to any hidden fees that were not discussed with you in advance.

9. Don’t hesitate to contact other debt management agencies and get quotes for their services, too.

If you choose to do the work yourself, you’ll likely do a better job than a company would – plus you’ll save a lot of money in fees.

Here’s where to begin:

1. Get a copy of all three of your credit reports. This will let you see the exact amount of the debt, its current status, any collection activity, when you opened the account, and how your debts affect your credit reports. You can get one free credit report each year from each of the three credit bureaus.

2. Know how much you can afford. You don’t want to reach a debt settlement and then find out you cannot afford the lump sum payment or the installments.

3. Negotiate with the original creditor. When possible, negotiate your debt settlement with the original creditor, not a collection agency. If you don’t reach a favorable settlement, then wait until your account goes to a collection agency. Sometimes, the longer you hold out, the better the offer.

4. Call the creditor. Often, creditors will work with you when you initiate the call. When you have money problems, you’ll get a better result when you’re proactive. Explain your financial circumstances to your credit and how you got behind in your payments.

5. Ask for what you want. Customer service reps often have the authority to negotiate payment terms, lower your interest rate – reduce your minimum payments – waive late fees – extend the grace period – and work out a payment plan that you can afford.

6. Get to the right person. If the customer service rep doesn’t have the authority to negotiate a settlement, then ask to speak with a supervisor.

7. Find someone who truly wants to help you. If the first person doesn’t want to help you, then ask to speak with that person’s supervisor. You need to find a person who is willing to work with you to settle a debt. You’re wasting your time when you reach people who are not willing to help you – or people who offer you terms you can’t meet.

8. Don’t ask what the creditor is willing to accept. Instead, tell the creditor what you are willing and able to pay.

9. Accept the settlement offer when it’s in your favor. When it’s not to your liking, then wait for a better offer.

10. Never give up. You must persist. Creditors and their collection agencies usually won’t write off a large debt without a fight. Stick with your settlement plan and realize that it might take several months to achieve your goal.

11. When you succeed, thank the creditor. Make sure the creditor knows you’re grateful for their willingness to settle the debt.

12. Don’t be intimidated or afraid of the creditor’s law firm. If the creditor sends your account to its law firm, this doesn’t always mean they will sue you. In fact, some lawyers will cooperate with you more than the creditor will.

13. Get it in writing! Always get a signed agreement from the creditor spelling out the terms of your settlement before you make a payment.