Rateworks auto loan refinance
June 19, 2024

What is a Car Loan Settlement?

A car loan settlement is a financial agreement between a borrower and lender to pay off a car loan for less than the outstanding balance. Here’s what you need to know about car loan settlements.

What is a car loan settlement?
Written by

Jennifer Moore

Buying a car is one of the most significant expenses you will ever undertake. In fact, an article from Business Insider suggests that the purchase of your car falls in line only after buying a home or vacation home, paying for a college education, and paying for taxes. So, when you decide it's time to buy a car, it isn’t a decision to be made lightly. You need to ensure you not only have the funds to pay for any upfront expenses and your monthly payments but also any expenses that accompany car ownership—such as gas, insurance, maintenance and repairs, etc.

Lenders take on a big risk when offering you car loan financing or refinancing to help you pay for your car. And, they expect that you will do what it takes to pay it back. When you don’t, you will not only experience a serious decline in your credit score but you may also be faced with a car loan settlement or the risk of collections. Neither one of these is a fun option.

How do you work with a lender on a car loan settlement?

What is a Car Loan Settlement?

A car loan settlement occurs when you find yourself unable to keep up with your car loan payments, often due to being "underwater." This means you owe more on the loan than the car is worth. Falling significantly behind on your payments can lead you to this situation.

When this happens, your lender will first attempt several methods to collect the outstanding debt. This might include sending you payment reminders, making direct phone calls, or even restructuring your payment schedule to make it more manageable. However, if these efforts fail, the situation may escalate, and the lender might turn to a debt settlement company as a last resort.

A debt settlement company steps in to help manage the situation by negotiating a new payoff structure between you and your lender. Their goal is to come to an agreement that reduces the overall debt, making it easier for you to pay off what you owe. 

Essentially, they act as a mediator to find a middle ground that minimizes your financial strain while allowing the lender to recover a portion of the loan. This new agreement typically involves a lump sum payment that is less than the total amount you owe but is accepted by the lender as a final settlement to clear your debt.

What are the benefits and drawbacks of a car loan settlement?

What are the Risks of an Auto Loan Settlement?

As we shared earlier, your lender takes on a risk when they agree to offer you a loan to pay for your car, or even to refinance your car. And, they want to ensure they get all that money back plus the interest you agreed to in your loan agreement. So, when it becomes clear that there is a risk that you are unable to uphold your end of the deal, they will do what they can to collect as much as possible.

But, while a car loan settlement might seem like a great option for you—because it may be less than what you own—it doesn’t come without risks.

Creditors Might Not Agree to Settle

While all of these risks are significant, this one is possibly the biggest. Sometimes, creditors may refuse to settle your debt. They may believe they can recover more money through continued collection efforts or even by repossessing and selling your vehicle. This refusal can leave you without the relief a settlement would offer, still facing the full amount of your debt plus any additional fees.

Taxes May be Required on Your Settlement 

When a creditor agrees to settle for less than what you owe, the forgiven portion of the debt could be considered taxable income by the IRS. This means you might have to pay taxes on the amount forgiven, which could add a financial burden at tax time.

The Process Can be Drawn Out and Stressful 

Negotiating a car loan settlement is not a quick or easy process. It involves a lot of back-and-forth communication with creditors and can be very stressful. The process can easily take three to five years, which is ironic since this might be your initial loan term. You’ll need to be prepared for a lengthy process that requires persistence and patience.

Credit Score Will be Damaged

Entering into a settlement can significantly impact your credit score, and for longer than many people realize. Missed payments leading up to a settlement and the settlement itself may be reported as negative information to credit bureaus, affecting your ability to secure future loans or favorable interest rates. This can sit on your credit report for seven years. But perhaps worse is that your score will also drop significantly, and you’ll have to demonstrate a good payment history and other responsible financial behaviors to get it back up—a process that can also take years.

You May End Up Owing More Than When You Started

Ideally, you should never take on a car payment or loan that represents more than 10 to 15% of your net income. Doing so can increase the risks of putting yourself in a situation where you can’t repay your loan. But perhaps even worse, if the settlement negotiations fail or drag on without a resolution, interest and penalty fees may continue to accrue. This can potentially increase the total amount you owe, making your financial situation more challenging than when you initially sought a settlement.

Ultimately, this is why so many people turn to auto loan refinancing to help lower their payment—and interest rate—to get to a payment that is easier to manage before they default. 

Is Your Loan Payment Too High? Get Started with RateWorks

If your circumstances have changed and your auto loan payment is too much to manage, it might be worth looking into an auto refinance option. Not only can this potentially save you on interest, but it may also help you get a lower monthly payment that is easier to manage.

Get started with RateWorks today.