Debt settlement agreement: How-to guide

No matter the protective measures taken, it is a simple market fact that borrowers default on loan terms or payments. In some cases, the outstanding debt amount may be too much for the debtor to manage, and continuing payments may force them into bankruptcy.

A creditor can decide that rather than gamble on a debtor’s future liquidity, an immediate debt settlement agreement will make the best of a declining situation. The borrower can get part of its burden lifted, eliminating continuing payments and growing default and interest costs without sacrificing its credit score or business relationships.

A debt settlement agreement allows the lender to forgive part of what a debtor owes if it receives an immediate settlement amount. The agreement is meant to release both parties from their obligations.  

Instructions checklist for debt collectors and debt settlement companies

Debt settlement negotiations

Debt settlement is a means of reducing or eliminating unsecured debt by negotiating an agreed-upon payoff amount with creditors or debt collectors. This usually doesn’t occur if a debt is secured since the lender will have the right to take the property that secures the loan in lieu of payment.

Tax liability for debt relief

Settling a debt can result in income tax liability. Creditors must report any forgiven debts in excess of $600 to the Internal Revenue Service (IRS), and the debtor will receive an IRS form for the amount of the forgiven debt. Talk to an attorney or a tax professional for additional details about these consequences.

Pros and cons of settling outstanding debt

There are pros and cons for the borrower looking to settle a debt. Although your monthly payments will be reduced, you usually need to make an immediate lump sum payment to complete the settlement. Your creditors may report any settlement to the credit bureaus. If you have a good credit score, this will have an immediate and large negative impact. If your credit score is bad, debt settlement or negotiation may have less impact and may be a better choice. Consider these and other personal factors before entering into a binding settlement agreement.

There are also pros and cons for the lender looking to settle the debt. They can recover money that would be unavailable if the debtor entered bankruptcy: even a partial settlement is better than nothing. However, the creditor is ending the possibility of obtaining the total amount that they are owed.

Debt settlement terms

Before sitting down to write, decide exactly what your goals are for the settlement. How much of the debt balance will be paid off? When will this payment need to be made? Clarify these terms before writing them down.

Properly review the debt settlement letter

The creditor or debt collector and the borrower must review the debt settlement agreement carefully. Ensure it is comprehensive and has all the details.

Signature formalities

Both debtor and creditor agree to sign two copies of the debt settlement agreement. One copy is kept by the creditor, and the other by the debtor.

You may decide to have the contract witnessed or notarized, depending on the nature of the terms.

Essential clauses of a debt settlement agreement

A debt settlement agreement constitutes the following provisions.

Introduction

This section identifies the document as a debt settlement agreement. Provide the details of the parties involved and the agreement's effective date. The effective date is generally the date on which the agreement is signed.

The parties must be the same as those who signed the original document that generated the debt. If there is a new signer, ensure they are the agent of the same company and hold the same designation. For example, if the manager signs the agreement on behalf of the debt settlement company and leaves the company in the future, then the new signee would be the new person appointed by the company as the manager.

Recitals

The “whereas” clauses, referred to as recitals, define the world of the agreement and offer key background information about the parties. Put in the effective date of the original loan agreement (or when the promissory note or other financial documents were signed). Write the loan amount that was provided.

You must also mention how the borrower is in default under the terms of the agreement or other documents. You must attach a signed copy of the loan agreement or other document along with the debt settlement agreement.

Acknowledgment of existing obligation

In this part, both parties acknowledge the debt owed by the borrower. Mention the amount of the original debt too.

Settlement amount

This section clarifies the amount that the lender is accepting from the borrower to settle the debt.

Lender’s release

It is the lender’s promise that after the signing of the agreement, and the taking of all needed actions under the agreement, it is giving up all of its rights to seek the full original amount of the debt or take any other actions against the debtor.

However, the lender is not releasing any claims that arise under the settlement agreement. For example, if the debtor fails to pay the settlement amount, the lender is still entitled to bring a lawsuit to obtain that money.

Debtor’s release

This clause outlines the debtor’s promise that after the signing of the agreement and taking all needed actions under the agreement, it is giving up all of its rights to sue or take any other actions against the lender.

But this doesn’t mean that the debtor is releasing any claims that arise under the settlement agreement. For example, if the lender is found to have assigned the debt to a third party violating the agreement, the debtor can bring a lawsuit alleging a breach.

Representations and warranties of the parties

The lender here is swearing that it hasn’t assigned the debt to a third party (in other words, this settlement agreement will be effective simply between the parties). Most of the remaining clauses are applicable only if the debtor or the lender are not individuals (i.e., they are partnerships, corporations, etc.).

The parties can also use this section to list additional promises, understandings, and assumptions. For example, the lender may require the debtor to make a statement about its current financial situation before settling a debt.

Effective time of releases

This section states that the releases become effective when the agreement is signed and the debtor pays the money.

Additional terms

This is an optional provision that can include any additional terms that haven’t already been listed. For example, if the parties exchange confidential information, you may want to include a provision governing the protection of that information.

Notices

It lists the addresses to which all official or legal correspondence should be delivered. Write a mailing address for each of the parties to the agreement.

Successors and assigns

It states that the agreement will be passed on to either party’s successors and assigns and that neither party can transfer its obligations under the agreement without the prior written consent of the other party.

Waiver and amendment

It explains that neither party can ignore or dismiss any part of the agreement and that any changes to the agreement will be in writing and signed by both parties.

Entire agreement

Here, the parties agree that the contract they’re signing is “the agreement” about the issues involved.

Severability

This clause protects the terms of the agreement as a whole, even if one part is later invalidated.

Governing law

This section allows the parties to choose the state laws that will be used to interpret the agreement.

Voluntary execution of the agreement

It indicates that all parties have had time to review and understand the agreement and have had sufficient opportunity to obtain legal representation (if desired).

Counterparts; electronic signatures

The parties can sign the agreement from different locations using electronic signatures in this provision.

Since now you know the important clauses of a debt settlement agreement, creating an agreement suiting your needs can be a breeze. However, using a professional debt settlement agreement template makes this job a lot simpler.

Though you can find a lot of online template providers, to use their templates, you might need to pay for them. LegalZoom offers a professional debt settlement template that you can use readily. Simply answer the guided questionnaire, complete the form, and download the document created from the template for free. It is that easy. 

In case your debt settlement agreement is complicated or there are multiple debts, it is better to take the help of an attorney. They can help you draft a document that will meet your specific needs.

Frequently asked questions

What’s a debt settlement agreement?

When a borrower defaults on a loan, it can cause stress and conflict for everyone involved. That's where a debt settlement agreement, also known as a debt settlement letter, comes in. Rather than chasing down or avoiding payments, an agreement can help the parties come together and renegotiate terms. The goal is to establish new rules to settle loans quickly and amicably that help the borrower avoid defaulting again.

What key details are required to complete a debt settlement agreement?

Here's the information you'll need to have handy to complete your debt settlement agreement:

• Who it's coming from: Determine if a business or individual is sending the document and have the name and contact information ready.
• Who it's going to: Know who this document is going to and have the individual or business name and contact information ready. If it's a business, make sure you know the business type (LLC, corporation, etc.).
• Which state will govern it: Specify a state so it's clear what laws apply to the document.
• Subject matter: Have information about the amounts paid and outstanding balance.