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What Happens When You Settle a Debt?

Sarah Edwards | April 11, 2024

Sarah Edwards
Legal Expert
Sarah Edwards, BS

Sarah Edwards is a professional researcher and writer specializing in legal content. An Emerson College alumna, she holds a Bachelor of Science in Communication from the prestigious Boston institution.

Edited by Hannah Locklear

Hannah Locklear
Editor at SoloSuit
Hannah Locklear, BA

Hannah Locklear is SoloSuit’s Marketing and Impact Manager. With an educational background in Linguistics, Spanish, and International Development from Brigham Young University, Hannah has also worked as a legal support specialist for several years.

Fact-checked by George Simons, JD/MBA

George Simons
Co-Founder of SoloSuit
George Simons, JD/MBA

George Simons is the co-founder and CEO of SoloSuit. He has helped Americans protect over $1 billion from predatory debt lawsuits. George graduated from BYU Law school in 2020 with a JD/MBA. In his spare time, George likes to cook, because he likes to eat.

Summary: When you settle a debt, you pay less than the original amount to clear your name of the debt. Debt settlement stops collection calls and further legal issues, but it can lower your credit score temporarily and the forgiven debt is considered taxable income. SoloSettle can help you reach a debt settlement for less and regain your financial freedom.

If you owe a debt that you can’t afford to repay, you may consider settling it. The settlement process involves paying a portion of the amount owed in return for wiping your account with the creditor clean. Sometimes, creditors agree to a settlement, especially if they don’t believe you can fully repay them.

Settling a debt can be advantageous to someone who can’t keep up with minimum payments or whose debt is in collections. You’ll move on free from further collections activity against you without needing to go through bankruptcy.

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What is the life cycle of an unpaid debt?

The debt life cycle starts with a debt you can’t afford to repay in full. Typically, your creditor will try to get you on board with repaying the debt according to your original agreement. If you fail to make any payment arrangements following a certain period — usually three to nine months — your creditor will charge off your account.

A charge-off occurs when a creditor has given up hope that a debt will be paid off. It is a derogatory entry on your credit report that can significantly hurt your score.

Following a charge-off, the account will go into collections. Some creditors use an in-house team for collections, while others sell overdue accounts to debt collectors.

Once your account goes into collections, it becomes easier to negotiate a debt settlement. The collections agency knows that it may be unsuccessful in collecting the total amount of the debt and that it won’t be worth it to pursue further collections against you.

Usually, debt collectors start the collections process by offering you payment arrangements. In some cases, they may provide you with an offer of settlement. You’ll receive a letter from them detailing the debt you owe and your various payment alternatives.

Ask debt collectors to validate your debt

You should always ask debt collectors you’re unfamiliar with to validate your debt before engaging in further communications with them. You can do this by sending a Debt Validation Letter.

In your letter, ask them to include the following specific information in their validation letter:

  • Confirmation of the debt and the current amount due
  • Proof that you are the owner of the debt, such as a signed contract
  • Confirmation that the debt is within the statute of limitations
  • Verification that they are a licensed debt collector in your state
  • Proof of the transfer of ownership of the debt from your original creditor

If the debt collector provides you with the requisite information to validate your debt, you can decide whether you want to settle the debt or set up payment arrangements.

Debt collectors that fail to respond to these letters probably don’t have the information necessary to validate the debt. If they report any adverse information to the credit reporting bureaus, you can ask them to delete it.

Let’s look at an example.

Example: Annie falls seriously behind on her credit card payments, and after almost six months of missed payments, the credit card company charges off the account and transfers it to collections. When the debt collectors come calling, Annie uses SoloSuit to send a Debt Validation Letter. Unfortunately, they have everything they need to verify the debt amount she owes. After a few more months, the collection agency files a lawsuit against Annie. She responds to the lawsuit to give herself time to work out a plan. Next, Annie uses SoloSettle to reach out about a debt settlement plan. She ends up settling the debt for 75% of the original amount, saving her money and the stress of worrying about the debt any longer.

Should you repay a validated debt in full?

Paying an overdue, validated debt in full has certain advantages. You’ll be able to move on from a difficult situation without fear of further collection activity against you.

You won’t receive any additional phone calls from a debt collector concerning the obligation. In addition, your creditor will report the debt as paid in full.

Even though the debt entered collections, paying it means there will no longer be outstanding collections on your credit report. Your debt-to-income ratio will decline, which will improve your credit score over time.

Paying your debt in full also increases the chances of obtaining credit. If you don’t have any outstanding debts, there’s less reason for a lender to deny you credit.

While paid collections remain on your credit report for up to seven years, some newer credit score models don’t include them when calculating your credit rating. If the credit score model includes the account when calculating your score, its impact will decline as time passes.

These are the advantages of settling a validated debt

Settling a validated debt is best when you know you can’t afford to repay it. While settling debt won’t be as favorable for your credit score, it does stop future collection activity. You won’t need to worry about being the subject of a debt lawsuit. The harassing phone calls, emails, and letters will also stop.

When you settle a debt, you agree to pay a portion of its total value. Some debt collectors and creditors will allow you to settle for as little as 30% of the obligation. However, settlements of 50% to 60% of the debt’s value are more likely.

Usually, you’ll need to make a lump-sum payment to settle the debt and halt further collection activity. Some collection agencies will allow you to stagger payments over several months if you can't make the full payment at once.

If you don’t have the money to settle a debt, it’s best to set up payment arrangements. That way, you can continue to save toward a settlement while avoiding potential legal actions against you. As long as you remain compliant with your payment arrangement, debt collectors won’t call you, and you won’t receive a sudden summons for a lawsuit in the mail.

Thinking about settling a debt? SoloSettle makes it simple.

What happens to your credit score after you settle a debt?

Once you settle a debt, the debt collector or creditor will report your account as settled or partially paid. It will stop negatively reporting your account to the credit reporting bureaus, but the settlement will remain on your credit report for seven years. You may not see much immediate change to your credit score, but it will increase over time.

If you stay on top of your other credit obligations, your credit score will eventually improve. Some people can see double-digit score increases within six months, especially if they pay their debts following their agreements and eliminate any other obligations currently in collections.

Will setting up a payment arrangement for an account in collections improve my credit score?

You can set up a payment arrangement if you can’t afford to pay off a debt in collections through full repayment or settlement. A payment arrangement won’t help your credit score since there will still be an open collection account on your credit report. However, this arrangement can prevent the debt collector from filing a lawsuit against you.

If you set up a payment arrangement, adhere to it. In the meantime, make every effort to save enough money to settle the debt or repay it in full.

You will be taxed when you settle a debt

Beware: the IRS considers forgiven debt taxable income. This means that if you settle your debt for less than the original amount, you will have to include the remaining amount as part of your income when filing taxes the following year.

In other words, if you settle your debt this year, you may end up owing more in taxes to the IRS next year. That being said, debt settlement is still worth it, especially if you feel like you’re drowning in debt and want to start over again.

Follow these steps to settle a debt

After you’ve weighed the pros and cons of settling your debt, consider doing it yourself. You can follow these three steps to settle a debt:

  1. Respond to any pending debt lawsuits.
  2. Determine how much you can afford to pay, and send an offer.
  3. When an agreement is reached, get the debt settlement terms in writing.

SoloSettle negotiates a debt settlement for you and manages your agreement.

Check out this video to learn more:

What is SoloSuit?

SoloSuit makes it easy to fight debt collectors.

You can use SoloSuit to respond to a debt lawsuit, to send letters to collectors, and even to settle a debt.

SoloSuit's Answer service is a step-by-step web-app that asks you all the necessary questions to complete your Answer. Upon completion, we'll have an attorney review your document and we'll file it for you.

>>Read the FastCompany article: Debt Lawsuits Are Complicated: This Website Makes Them Simpler To Navigate

>>Read the NPR story on SoloSuit. (We can help you in all 50 states.)

How do I negotiate a debt settlement?

To find the answer to this question, we asked a debt lawyer for some tips. Below, we share what we learned.

To negotiate a debt settlement yourself, follow these tips:

  • Be truthful about your financial situation, as creditors often have detailed information about you.
  • Make a realistic offer, considering they will likely counteroffer.
  • For junk debt buyers, settlements of 10-35% of the total debt are typical, while original creditors may accept 50-75%.
  • Paint a picture of your financial hardship to the creditors or their lawyers.
  • Show proof of your limited ability to pay, like being on Social Security, facing multiple debts, or having wage garnishments.
  • Avoid threatening bankruptcy if you don't mean it, as this empty threat is often ineffective.
  • If you propose a payment plan, ensure it's realistic for your budget.

Check out the following video for more information on how to negotiate with creditors and debt collectors:

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