Collection agency said they were going to take me to court for litigation. what should I do?

Yes, a collection agency can sue you for the amount of debt plus their collection costs, and they can sue for you breaching your oral agreement to the settlement. The bottom line is they want to get paid, and I suspect that they won't sue as long as you make regular payments. $40 a month may be enough to make them not sue you, depending on what your total debt is, but it may not be enough.

Disclaimer: Please note that this answer does not constitute legal advice, and should not be relied on, since each state has different laws, each situation is fact specific, and it is impossible to evaluate a legal problem without a comprehensive consultation and review of all the facts and documents at issue. This answer does not create an attorney-client relationship.