Debt Settlement

Debt settlement is also known as debt arbitration or debt negotiation. it is an approach to debt reduction which involves an agreement between the debtor and creditor. They arrive at a number, less than the full amount that will constitute payment in full.

As long as the consumer can continue to make their minimum monthly payments creditors will not negotiate a lower balance. When payments stop, balances continue to grow because of late fees and interest accruing.

Consumers may arrange their own settlement or may hire a lawyer to act on their behalf, or use debt settlement companies. Some companies charge a large fee up front whereas others take a monthly fee. Look for companies that charge no more than 20 percent of the amount by which they are able to reduce the outstanding balance owed.

History of Debt Settlement

Lenders have been practicing debt settlement since time immemorial. As a business practice, though, it became prominent in America during the late 1980s and early 1990s when bank deregulation loosened consumer credit practices, and was followed by an economic recession that put consumers in a position of financial hardship.

With charge-offs (debts written-off by banks) on the rise, banks created debt settlement departments authorized to negotiate with defaulted debtors to reduce the outstanding balances in hopes to some of the funds that would otherwise be lost if the cardholder filed for Chapter 7 bankruptcy. Settlements ranged between 25% and 65% of the balance outstanding.

How Debt Settlement Works

The debt settlement company negotiates with creditors to reduce the overall debts in exchange for an agreement for regular payments going forward. This helps the debtor avoid the stigma and intrusive court-mandated controls of bankruptcy while substantially lowering, sometimes by more than fifty percent, their debt balances. The creditor regains trust that the borrower intends to pay back what he can of the loans and will file bankruptcy.

There are drawbacks. Credit reports will show debt settlements and FICO scores will be lowered.

Incentives for Creditors

The primary incentive is to recover funds they’d lose if the debtor filed bankruptcy. The other key incentive is that the creditor can often recover more funds than through other collection methods. Collection agencies tend to charge commissions as high as 40 percent on recovered funds. Bad debt purchasers buy portfolios of unpaid debts from creditors who have given up trying to collect, and pay between 1 and 7 cents on the dollar for these debts.

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