Understanding Debt Settlement And How It Works

Read Time: 8 minutes

Owe more money to creditors than you can afford to pay back? Being underwater with debt can feel overwhelming, but don’t despair.

There are strategies you can pursue to dig out of debt and wipe your financial slate clean. One of them is debt settlement, which aims to pay off your debtors for less than you owe. 

Take the time to better comprehend how debt settlement works and if it’s right for you as well as the benefits and drawbacks, steps involved, and alternatives to consider.

Debt settlement explained

Debt settlement is an option to eliminate your unsecured debt. It involves directly negotiating with creditors to decrease the total amount you owe, often resulting in a lump sum payment.

“Your creditors are going to get paid something with debt settlement – just not 100%,” explains Greg Fitzgerald, a debt and settlement protection attorney at Fitzgerald & Campbell, APLC.

Here’s how debt settlement works: First, you must default on your obligation to repay your debt (meaning you must stop paying your creditors). That’s because no unsecured creditor is going to accept less money so long as you continue to make your payments.

“Instead of making your payments, you save up that money to create a settlement fund,” continues Fitzgerald. “For example, let’s say you owed $20,000 in credit card debt. By defaulting and salting away the $500 minimum payments, after one year you will have $6,000 saved.

You will also be delinquent for 12 months and, because of that, your creditors will be open to accepting a settlement that equates to less than full payment – so long as that negotiated settlement is paid in full.”

Using this example, your $6,000 saved would be used to settle one or more of the outstanding accounts for less than 100% of what is owed. A $12,000 account may accept $6,000 as a settlement in full. While settlements can be in a lump sum or in payments, the best settlements are lump sum.

For this reason, it is better to save up to have a lump sum rather than agree to settlements that have payment plans.

“Debt settlement is typically used when you are struggling to make payments on your existing debt and you are working to avoid bankruptcy. It’s a way to reach a compromise with creditors to solve your debt issues,” adds Fitzgerald.

The pros and cons of debt settlement

Dennis Shishikov, head of growth at Awning and an adjunct professor of economics at City University of New York, says the biggest advantage of pursuing debt settlement “is that you can potentially pay less than what you initially owed, and you can avoid bankruptcy.”

But the disadvantages are numerous. First, your credit score will drop significantly. The fees charged by a debt settlement company or attorney can be high, too.

You may owe taxes on your forgiven debt, as well. Plus, there’s no guarantee that creditors will accept your settlement offer.

“You can also be subject to the collections process and be inundated with collection calls, letters, emails, and texts,” Fitzgerald says, noting that collectors can no longer contact you directly if you are represented by an attorney. “You can also be sued on the debt you owe, but with the right lawyer this can be managed because the court process can take many months and even years – allowing you ample time to save for an eventual settlement.” 

Good candidates for debt settlement

Debt settlement is not a one-size-fits-all strategy. It’s best for those deep in debt who have no realistic prospect of paying off what they owe due to financial hardships like a job loss or medical crisis.

“I have a friend who was drowning in debt after a series of unfortunate events, including job loss,” Shirshikov recalls. “The thought of filing for bankruptcy didn’t sit well with him. So he chose debt settlement; while it was a tough path with a temporary blow to his credit, it worked out in the end because he had no other realistic options.”

According to Fitzgerald, anyone who does not qualify for or doesn’t want to file bankruptcy or has a type of debt that is not dischargeable in bankruptcy – such as student loans – and has not been able to reduce their debt balances should seriously consider debt settlement as an option.

The steps involved with debt settlement

There are several steps you need to follow to complete the debt settlement process, which collectively can take months to years:

  1. Choose and partner with a professional, either a debt settlement company or an attorney with experience with debt settlement. “A lawyer will usually get the best settlements and offer the most protection. Only a lawyer can file your bankruptcy, which creditors know. This is leverage that non-lawyers don’t have. Also, lawyers can stop collection activity against you. And if you get sued for the debt, only a lawyer can assist you in court,” notes Fitzgerald.
  2. Stop making payments to your creditors.
  3. Determine a budget and start saving. Think carefully about how much you can save per month for a settlement fund, which must be a viable amount. “Saving $100 per month when you owe $50,000 is not a viable debt settlement plan, for example,” Fitzgerald says. Once you reach a viable amount, begin making deposits into a special account designated for settlement only.
  4. Negotiate a settlement with your creditors. “Many are understandably in a rush to settle as soon as possible. However, you must not appear too motivated to settle, as creditors will perceive this and insist on higher amounts. That’s why someone with experience in debt settlement negotiations is invaluable.”
  5. Agree on a settlement amount and pay off your creditors. The settlement must also be properly documented legally.
  6. Pay any fees and taxes involved. 

Who offers debt settlement services?

If you are determined to pursue debt settlement, you can hire a debt settlement company, a law firm or individual lawyer specializing in debt settlement, or a financial counseling organization that offers these services. Shop around carefully for the right professional, and ask for referrals from anyone you trust who has gone through the process themselves.

“As for what they charge, it’s a mixed bag,” says Shirshikov. “Some charge a percentage of the settled debt, often around 20% to 25%. Others bill a percentage of the debt you enrolled.”

If the fee and promised services sound too good to be true, trust your gut and look elsewhere.

“Over-promising and under-delivery is a problem in this industry, as the debt settlement field has a historically bad reputation with many great marketers and salespeople who are not so great at the actual services provided,” cautions Fitzgerald. “The good news is that in some states, like California, a consumer cannot be charged any fees until the settlement is achieved and significant disclosures are required. The fees in California are usually based on the amount of debt owed, ranging from 15% to 40%.”

Realistic expectations about debt settlement

It’s important to be realistic about what debt settlement can do and cannot do and the repercussions of this decision.

“Debt settlement can reduce your debt load. It’s not a magic wand. It can take years and damage your credit score, and there’s no guarantee of how much you will save,” suggests Shirshikov. “The process requires patience, discipline, and a steady nerve because creditors may not play ball and legal actions are possible. It’s like going on a financial diet: The results are not instant, and there is no guarantee of success. But for many, it’s worth a shot.”

Alternatives to debt settlement

Of course, debt settlement isn’t your only choice. You can also explore debt counseling, in which an expert can offer education and guidance on managing your debts without necessarily helping you to negotiate or lower what you owe.

Alternatively, you can opt for a debt management plan, which entails simplifying and organizing multiple debts into a single monthly payment, commonly with lower interest rates. Or, as a last resort, there’s bankruptcy, a legal proceeding that can discharge certain debts completely or enable a restructured repayment plan.

“These are all different flavors of handling debt, but they come with different recipes,” Shirshikov continues. “Debt management is like working with a personal trainer: You get a plan, usually with lower interest rates, and you pay off your debt over time. Debt counseling is more of an educational approach, teaching you how to work with money better. Bankruptcy, on the other hand, is like hitting the emergency brake, where you either liquidate your assets to pay off the debt or create a repayment plan. Debt settlement is different – it’s like bartering at a market, trying to negotiate your debt down to a more manageable size without having to pay the full amount.”

Another option is a debt consolidation loan in which you pay off your existing debts with a new form of financing – such as a home equity loan or home equity line of credit, ideally at a more affordable and fixed interest rate than what your credit cards are charging. 

While debt settlement may offer immediate relief, exploring alternatives before committing is essential, per Damon Duncan, a bankruptcy attorney at Duncan Law, LLP.

“Bankruptcy, in particular, could be a viable alternative for those overwhelmed by debt,” he says. “But while bankruptcy can provide a fresh start and legal protection from creditors, it will impact your credit score and financial record significantly. Therefore, consulting with a financial counselor or attorney is crucial to fully understand the implications and ensure you make the right choice for your unique circumstances.”

Erik J. Martin

Erik J. Martin is a Chicago area-based freelance writer and public relations expert whose articles have been featured in AARP The Magazine, Reader’s Digest, The Costco Connection, Bankrate, Forbes Advisor, The Chicago Tribune, and other publications. He often writes on topics related to real estate, personal finance, technology, health care, insurance, and entertainment. He also publishes several blogs, including Martinspiration.com and Cineversegroup.com, and hosts the Cineversary podcast (Cineversary.com).

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