How do debt settlement plans work?

Question

Let's say that you owe $10,000 to several creditors. You can't pay the whole amount, but you do have enough on hand to offer everyone 40-60 cents on the dollar. And there are debt settlement companies that (for a fee, taken at the "back" end), can negotiate such large discounts.

What allows this to happen? Is it because the creditors will take a larger "haircut" than, say, 40-50 cents on the dollar if they sell it to debt buyers, etc.? Does that give them an incentive to settle?

Are there instances where creditors will sell their debt to third parties for less than what they are offered in settlement? Are debtors given the right of first refusal if creditors do decide to sell their debt?

Answer 1

As unsecured debt becomes more delinquent the likelihood it will be repaid decreases. There are various debt collection routes that can be taken, but typically it gets to someone willing to settle for a fraction of the debt because they're either prepared to write it off as uncollectable or sell the debt off to a third party for a fraction of the original amount.

Typically the only way to have any bargaining power with unsecured debt is to first stop paying so the account becomes delinquent 120+ days. You tank your credit score, and make the creditors doubt they'll get anything from you. At that point to settle for less than you owe you'd also need a lump sum to offer.

Practices may vary by debt settlement companies, but my understanding is that if you have a lump sum they just negotiate on your behalf to settle your debt for say 40% of original debt but you pay them 50% of the original amount so they make 10%. If you don't have a lump sum they set up an account that you can pay into monthly, then when your account has sufficient balance to make a lump sum payment against one of your debts they'd negotiate that debt and pay it off, basically an escrow account. They are not extending you credit (you're not credit-worthy).

These debt settlement companies aren't protecting your credit score, it has to be tanked to have a chance to settle for a fraction of original amount. They aren't likely saving you any money, you could negotiate the same reduced payment and skip paying the settlement company. They also aren't protecting you from any legal action that a creditor may take to collect (some might offer legal services if you get sued, for an extra fee, but they aren't doing anything that would stop it from happening).

This is very different from debt consolidation which is a new loan used to pay off other debts but at a (hopefully) lower interest rate. You can go through debt consolidation without tanking your credit score.

It's also worth noting that just like debt collection companies, debt settlement companies have been known to employ shady business practices/offer poor advice. Bankruptcy can be a better option for some people that feel trapped by debt.

Answer 2

Creditors sell off uncollectable debt all the time to debt collectors, many times for pennies on the dollar. In those situations, almost every dollar they are able to get from you are pure profit. The original creditor does this under the assumption that they at least get SOME money that they otherwise probably wouldn't recover.

You do not get any right of refusal in the matter.