Debt settlement is an agreement between a consumer (or business) and a creditor where the creditor agrees to accept less than the full balance as satisfaction of the debt. Sometimes this type of transaction is also referred to as a “settlement in full,” since the revised agreement fully satisfies the entire balance on the account. For example, if you owe ABC Bank $10,000 and negotiate a 35% settlement, that means you would pay the creditor only $3,500. What happens to the remaining $6,500? It gets canceled (i.e., forgiven) by the creditor, and of course this represents a loss of that amount to the bank.

When people first hear about settlements, they immediately think, “That sounds too good to be true. Why would a bank want to accept a loss like that? Won’t they just automatically file a lawsuit against me for the full amount?”

The truth is that it’s the *banks* themselves that want to settle. The reason they do this is not because they want to show mercy or kindness! It’s a straightforward financial decision. The big banks have calculated that the farther behind an account gets, the greater the risk they will never recover anything at all. The person may have lost their job and have no income, so there are no wages to go after. Or they may have recently lost a property to foreclosure and now the creditor has trouble locating the person after they’ve moved to another state. In many cases, people just file bankruptcy to take care of their debt problems. Under Chapter 7 bankruptcy, the creditor will receive nothing on the claim – zero! Under Chapter 13, they will receive some amount back, but they have no control over how much since that is determined by the court (based on the debtor’s ability to make payments). And most Ch. 13 plans last for five years, so it takes a very long time for the creditor to get paid that way.

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Instead of taking a chance on collecting zero, or collection a small fraction of the balance over five years, most banks would rather cut their losses and resolve the account. This is the rationale behind the banks’ motivation to settle. It helps them reduce the loss they would otherwise be risking. Every major creditor has their own individual policy on such settlements. Some are more difficult than others to achieve settlements with, but it’s common to see debts settled for 35-40% of the balance, and settlements of 20-30% are quite common with some creditors.

In my professional opinion, debt settlement is a very good strategy to consider if you wish to avoid bankruptcy, especially if you are not eligible for Chapter 7 (where all the debts go away) and have to file under Chapter 13. Instead of a 5-year path to recovery, while you are under the financial supervision of the court the whole time, you can privately negotiate settlements and have a much faster path to recovery. Debt settlement is not for everyone who is experiencing a financial crisis, but it’s certainly a viable and effective strategy in the right circumstances!

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