How Do Debt Relief Programs Work?

Debt relief can take many forms, from consolidating debt to filing for bankruptcy. A so-called debt relief program, also known as a debt settlement program, is a detailed road map designed to help people reduce their balances, secure lower interest rates or improve repayment terms.

For a fee, counselors at debt relief companies will negotiate with your creditors on your behalf, working to lower certain types of consumer debt to a more manageable level.

How Does A Debt Relief Program Work?

Debt relief involves bargaining with creditors to decrease the amount you owe. Some lenders may be willing to write off some of the debt, extend the payoff deadline or lower the debt’s interest rate.

Before you can hammer out new agreements with your lenders, you must show that you can’t afford your current monthly payments. The simplest way to demonstrate your hardship to creditors is to fall behind on your payments.

In fact, if you hire a debt relief company, you might be instructed to stop paying your debt for a period of time. Your delinquency gives the company leverage with your creditors.

“Usually, I find debt settlement options are best for those with old past-due debts, not those [who are] merely delinquent,” says investment advisor representative John Jones of Heritage Financial in Newberry, Florida.

That’s because old debt is already at a high risk of never being paid. Creditors would rather collect part of the debt than none, so they may be more willing to strike a deal for less than the amount you owe.

Pros and Cons of Debt Relief Programs

While debt relief can liberate you from some of your debt burden, it also has drawbacks.

Pros of Debt Relief

You may be able to settle your debts for less than the total amount owed.
Debt settlement programs can often resolve your debts more quickly than debt repayment plans, which may take years. Once a settlement is reached, you may be able to eliminate multiple debts with a lump-sum payment or through negotiated payment arrangements.
Debt settlement can provide an alternative to filing for bankruptcy. By negotiating settlements with creditors, you may be able to avoid the long-term financial repercussions of bankruptcy. Jones notes that a debt relief program may enable you to maintain greater privacy, too, “as credit reports are more personal and not public record [like] bankruptcy filings.”

Cons of Debt Relief

Debt settlement typically involves stopping your payments to creditors. Any late payments, defaults or collections that may result can significantly damage your credit score. Even after you’ve paid your reduced debts, the record of missed payments and settlements can remain on your credit report for years.
Debt settlement companies often charge fees for their services, typically a percentage of the enrolled debt. Paying a fee will reduce the amount that will go toward lowering your debt.
You may have to pay tax on your forgiven debt. The IRS usually considers it taxable income, but there are exceptions. If the sum exceeds $600, the financial institution that forgave the debt will issue you an IRS Form 1099-C—but even if you don’t receive the form, the canceled debt may in some cases be included in your tax liability.
There’s no guarantee that creditors will agree to settle your debts for a reduced amount. Even if a settlement is reached, it may not be as favorable as expected, and some creditors may simply refuse to negotiate. Moreover, during the time spent negotiating, interest and late fees on your debt may continue to accrue, potentially offsetting any savings from a settlement.

What Kind of Debt Is Eligible For Debt Settlement?

Debt settlement firms specialize in negotiating with creditors to reduce the outstanding balances on unsecured debts. Unsecured debt is debt without collateral. Examples include credit card balances, personal loans, medical bills and store credit cards.

Debt settlement is usually not applicable to secured debts like mortgages, home equity loans and loans for cars, boats and RVs. In those cases, the property serves as collateral to secure the loan. Other kinds of loans that require collateral for approval include secured credit cards, furniture financing and jewelry loans. Because of this, secured debts are not eligible for settlement.

In essence, unsecured debt relies solely on the borrower’s creditworthiness, while secured debt offers lenders assurance through the pledge of tangible assets.

How to Choose A Debt Relief Company

Choosing a trustworthy debt settlement company calls for careful research and evaluation.

Start by examining several companies, focusing on their reputation, success rates and client feedback. You can look at sites like TrustPilot or Yelp to see their ratings and customers’ reactions. Forbes Advisor has also identified the best debt settlement companies based on various relevant factors. Look for accreditation by recognized organizations such as the Better Business Bureau.

You’ll want a company that provides effective, clear and complete communication about the debt settlement process, risks and alternatives. Seek experienced negotiators to advocate on your behalf. If possible, verify their track record with past clients.

Red Flags To Watch Out For

It’s easy to fall for claims made by a less-than-ethical company when you’re drowning in debt and vulnerable to promises of extremely low payments and fast settlements.

When selecting a debt settlement company, it’s crucial to watch out for these warning signs:

Unrealistic promises. Be wary of companies that guarantee specific outcomes or promise to settle your debts for pennies on the dollar. Debt settlement programs are based on negotiation, and there are no guarantees of success. Companies that make lofty promises to lure clients may be deceptive.
Upfront fees. Avoid companies that require large upfront fees before providing any services. Reputable debt settlement companies typically charge fees based on the results they achieve; often they charge a percentage of the amount saved through settlement. Upfront fees can indicate a lack of accountability and may leave you financially vulnerable if the company fails to deliver on its promises.
Lack of transparency. Watch out for companies that don’t reveal their fees, which services they provide, or the risks involved in debt settlement. If a company is evasive or unwilling to answer your questions, it may be a red flag indicating dishonesty or incompetence. Reliable companies should provide clear and comprehensive information about their processes and fees as well as alternatives to debt settlement.

Bottom Line

Before you jump into a debt relief program, evaluate the potential savings against the associated costs. While a debt relief program can reduce your overall debt burden, it often comes with fees—such as settlement fees or service charges—that can lessen the total amount you save.

Settling debt can also negatively impact your creditworthiness. This may limit your access to credit, affect employment opportunities or hamper future loan approvals.