A debt settlement agreement states there is a reduction in a debt that a creditor and debtor agree on in order to regard the payment as paid in full.

What Is a Debt Settlement Agreement?

If a debtor takes on too much debt and cannot continue making payments, a creditor might agree to a debt settlement agreement. As a result, the lender forgives part of the debt and receives an immediate settlement amount. This agreement releases both parties from any obligation to each other.  The agreement eliminates the debtor's need to continue making payments and accruing interest and default costs without affecting his business relationships. 

Debt settlement eliminates or reduces unsecured debt through negotiating an agreed-upon payoff amount. However, if you settle a debt, it can result in income tax liability. Creditors have to report to the IRS any forgiven debt that exceeds $600. 

Pros and Cons of Debt Settlement Agreement

Borrowers must consider several pros and cons before agreeing to a debt settlement. Although there is a reduction in the monthly payment, the settlement typically involves an immediate large sum payment. Creditors might also report the settlement to credit bureaus, thus affecting the credit score. However, the credit report might state that the payment is settled instead of paid in full. Anything other than paid in full could affect your credit score.

Lenders also must look at the pros and cons when settling a debt. The lender can recover money that they might not receive if the debtor enters bankruptcy. However, the agreement ends the possibility of receiving the total owed amount.  

Key Terms Found in a Debt Settlement Letter

When reviewing a debt settlement letter, you should pay attention to a few specific terms.

  • Settlement. The settlement amount typically represents less money than the entire balance. A settlement cannot be sold to a different collection agent. A creditor does not need to deal with a settlement.
  • Structured settlement. This specifies the payments made over a certain time frame.
  • Collection agent. You might deal with one of two different types of agents: those who work contractually or those who purchase accounts from creditors.
  • Original creditor. This usually involves either the provider who administered a specific service or a bank that supplied the credit card. 
  • Collection account. Any of the rights to a delinquent medical debt or credit card are an asset. The collection account refers to collecting the delinquent debt.
  • Hard limit. This refers to the amount in your budget that you can pay for your settlement.

Steps to Negotiating a Debt Settlement

Before you start to negotiate a debt settlement, find out who owns the collection account. Visit AnnualCreditReport.com to find contact information.

Contact the original creditor or collection agent. Agents typically earn 4 to 8 cents for each dollar. Their goal is to obtain around 11 cents for each dollar. When you negotiate, start around 5 cents for each dollar.

For original creditors, you should wait for the creditor to initiate the negotiations. If you are delinquent more than 30 days, you might begin to receive collection calls. You might also receive settlement letters. 

If you receive settlement letters, contact the creditor and start negotiating. Bring up the reason for not making a payment and your hard limit. Be prepared to share your hardship, since creditors might give you a break if you can justify your financial misstep. 

Keep in mind that original creditors seek more money compared with collection agents. Begin negotiating at around 40 cents for each dollar. If the amount reaches 60 cents for each dollar, halt negotiations and resume in about a month.

After you agree on a spoken settlement, make sure the agent or creditor sends it to you in writing. A settlement is a contract between you and the creditor or agent. You can receive the document via mail, fax, or PDF in an email, and all three types are court admissible. 

What If I Don't Receive a Written Settlement?

Since the written settlement letters can act as evidence, you need to make sure you have a copy. If the creditor or agent will not write down the deal, they may not come through from the verbal agreement. However, some creditors will not send a settlement agreement until you make a payment. 

Some credit card firms might claim that they will provide a contract once they receive a payment. If that's the case, consider opening a separate checking account. Pay the first payment from the structured settlement into this account and authorize the creditor to withdraw funds from this account.

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