What is Debt Settlement? Meaning, Definition, Benefits

What is debt settlement?

Before initiating our discussion regarding what is debt settlement?s First let's revise the meaning of two words it is made of.

Debt settlement is a union of two words namely:

1. Debt and
2. Settlement.

The individual meaning of these two words is as follows:

1. Debt means the total amount of money borrowed by an entity like an individual, company, firm, and so on.
2. Settlement implies an agreement between two or more parties to resolve issues between them.

So based on the above understanding now let's try to conclude the meaning of debt settlement.

Debt settlement means to make an agreement or do a settlement in relation with the sum of money borrowed and lent between the parties.

Debt settlement acts as a relief from the burden of debt, and it is also an alternative solution to the worst case of bankruptcy (insolvency).

Figure 1. What is debt settlement? Image credits © Prof. Mudit Katyani.

Debt settlement has shown its presence in various businesses and finance deals in the decade of 1980 and onwards. It became prominent in the United States of America (U.S.A), during banking deregulation (lower restrictions) which wiped off consumer-lending business and was succeeded by an economic recession (slow down).

Financial institutions like banks, authorized money-lender formed a separate department, especially to take care of debt settlement. This department was authorized to negotiate with the defaulted debtor to settle the debt-related outstanding balance.

Debt Settlement was done with an intention to recover funds (lent money) that would be otherwise lost, in case, if the party is declared and filed themselves for bankruptcy in the court of law.

Meaning of debt settlement

Following fifteen points convey the conceptual meaning of debt settlement:

1. Debt settlement is an approach to reduce, manage or settle the borrower's financial burden.
2. It is a process of doing conversation with creditors to make them agree and accept payment, which is less than the total amount payable to them.
3. It is a negotiation between parties (debtor and creditor), to convince or agree upon a reduced payment that will be considered as full and final payment.
4. In the process of debt settlement, a customer needs a lump sum cash balance to pay-off the debt, as and when it is completed.
5. If a customer, does not have initially cash or bank balance, he needs to build up enough funds during the process of debt-settlement and within a pre-determined period of time.
6. It helps to prepare a financial strategy with creditors to reduce the overall debts in exchange for a full and final payment.
7. It helps to prepare and advise upon the schedule of repayment to be made with creditors (lenders).
8. Repayment schedules help in releasing the payments either on a monthly, weekly or quarterly basis.
9. It helps to ensure the regular, proper (correct) and prompt (on-time) payments to be made to creditors (lender).
10. It helps in negotiating with the creditors on terms and conditions of repayment of the borrowed money.
11. In its process, the debt settlement company makes creditors agree to forgive a percentage of a total amount due to them.
12. The debt settlement company charges fees for their professional services rendered to party.
13. Fee charged by debt-settlement entity is based on the total unpaid amount by the party.
14. Debt-settlement entity may also charge fee based on percentage of savings on their forgiven debt.
15. It is also referred as:
    1. Arbitration of debt,
    2. Negotiation of debt and
    3. Settlement of credit.

Definition of debt settlement

According to Cambridge Dictionary, debt settlement is defined as follows.

“A financial agreement between a borrower and a lender in which the borrower pays back less than the full amount of a debt, and the lender agrees to accept this as full-payment.”

The definition of debt settlement in different perspectives:

1. General : Debt Settlement is the process of an agreement between the creditor and debtor to settle a pre-outstanding debt (sum of borrowed money) for a certain determined and negotiated amount of money.
2. Finance : Debt Settlement occurs when the creditor agrees to forgive a percentage of total account balance and accept the balance amount as a full and final settlement.
3. Academic : Debt Settlement is a process of negotiating with creditors to make them agree to accept the payment, which is less than the full amount owed (yet to be paid) by the creditor to the debtor.
4. Business : Debt settlement is an option to an entrepreneur to pay his debt at a concessional rate or reduced amount. This is a better practice rather than declaring bankruptcy (insolvency), to pay the debt.
5. Banking : Debt settlement helps the consumer to make monthly payments to company or bank that settles-debt. It helps the bank or financial institution to recover a part or negotiated money, rather than declaring the entire amount which is recoverable as bad debts.

Benefits of debt settlement

The benefits of debt settlement with respect to a company, an individual and others are depicted and explained below.

The benefits of debt settlement for a company in debt:

1. Reduce and restructure its overall debt.
2. Reduce the monthly instalments of its term loan.
3. Bargain with lenders to reduce lending rates on loan.
4. Extend the period of payment of debt.
5. Issue company shares to creditors, in lieu of their debt or borrowed money.
6. Directors can give personal guarantees to pay off their company's debt.

The benefits of debt settlement for individuals in debt:

1. Helps in revising the borrowed fund (debt).
2. Find a better and affordable loan rate.
3. Plan instalments with the total income earned.
4. Track credit card spending and EMI (Equated monthly instalments) of loan.
5. Seek lower interest rate on loans offered by banks or financial institutions.
6. Convert an existing (older) loan to a newer one.

The benefits of debt settlement for others who are in debt:

1. Reduce public debts by controlling the unplanned expenditure.
2. Assist in declining the national debt by making proper use of borrowed funds.
3. Make use of debt (borrowed) funds for productive business purposes and not for unproductive ones.