What is Debt Settlement and How Does It Work?

Read Time: 6 minutes

Debt settlement means a creditor has agreed to accept less than the amount a borrower owes as full payment. It may be an option when you have several late or missed payments or if your accounts have gone to collections.

The most common settlements occur with credit card debt but can also occur with medical bills, student loans, or other large unsecured debt amounts. It’s not an option for certain types of debt, such as a house that can be foreclosed on or a car that can be repossessed.

You can try to work out a debt settlement on your own or use a reputable debt settlement company to represent your interests. This may result in paying a lump sum, paying reduced amounts over time, or a complete debt discharge.

After a settlement is accepted, the creditor can’t continue to pursue you for the money and you don’t need to worry about getting sued over that individual debt.

Potential Downsides of Debt Settlement

Debt settlement can be a good option in many cases, but it has several potential downsides.

Negative impacts on your credit score. To settle, most creditors require an account to be delinquent. When you stop making payments during negotiations to demonstrate your inability to stay current, those missed or late payments will be reported to credit monitoring agencies.

As a result, your credit score will take a hit. In some instances, you could also get sued as a strong move by your creditors. Delinquent accounts and charged-off debt stays on credit reports for seven years.

Forgiven debt is taxable. Although you may get relief from your creditors, any forgiven amounts are considered income if the amount is over $600. It will be taxed, and your relief may be a net of much less than you anticipated.

Debt settlement can take a long time. Sometimes, it could take years to negotiate with creditors either on your own or through a debt settlement company. If you have multiple creditors, that will also extend the negotiation process. If you need relief sooner, look at other alternatives.

You may owe more than when you started. That may not make sense to you at first, but consider that interest still accrues on the debt when you stop making payments as a negotiating tactic. You may also get hit with late fees and other charges, pushing your debt higher than when you started.

You may not be able to settle.  Not all creditors will settle outstanding debts. Occasionally, creditors may also refuse to work with debt settlement companies.

There’s no guarantee you’ll get favorable terms. You can attempt to negotiate, but your settlement may not be resolved for significantly less, creating a lot of effort for little return.

You must pay a fee when a debt settles. Debt settlement companies can’t charge upfront fees. The fees associated with debt settlement services vary depending on local and state laws. A debt settlement company or debt attorney that attempts to charge you before the debt is settled is not legitimate.

Most charge a percentage of each debt they settle, which may be based on that debt’s balance when you enrolled it in the program. Others charge a percentage of the debt eliminated by the settlement.

For example, suppose you owe $20,000, and the settlement company negotiates a settlement for $10,000. The company may charge a 25% fee.

If the agency charges a percentage of settled debt, you’d pay the creditor $10,000 and pay the agency $5,000 in fees (25% of the $20,000 balance enrolled) for $15,000 out of pocket.

If the agency charges a percentage of eliminated debt, you’d pay the creditor $10,000 and the agency $2,500 in fees (25% of the $10,000 in eliminated debt) for $12,500 out of pocket.

Debt Settlement Alternatives

You have other options instead of pursuing debt settlement. Consider the following: 

Credit counseling. Consider working with a nonprofit credit counseling agency to assist you in coming up with a viable debt management plan. Make sure whatever agency you choose is accredited, such as American Consumer Credit Counseling, the National Foundation for Credit Counseling, or the Financial Counseling Association of America.

Some credit counselors will cost you little or nothing, and you’ll make payments to them rather than to your creditors. Chances are that you’ll be required to close all outstanding accounts until your debt is paid off.

Debt consolidation. You combine all your debts into a new single loan to pay off. This can reduce your monthly outlay, which buys you some financial breathing room until your finances improve.

You can work with a credit counseling agency or fund a debt consolidation loan on your own. The key is to refrain from tapping into your existing accounts after you pay them off, or you could wind up in much worse shape financially.

Balance transfers.  Many credit cards offer sweetheart introductory offers when you sign up, often with 0% APR for a set amount of time, which can be as much as 24 months. You can focus completely on paying down the principal during that time and perhaps make significant inroads on your debt.

The best card offers include no fees to transfer your outstanding balance but you may need to get creative if you have more debt that you want to transfer than the limit on the card allows. 

Bankruptcy. This is a last resort, but if you’ve got serious debt problems, it may be a decent alternative for you. Filing for Chapter 7 bankruptcy will remove most unsecured debt, like credit cards, medical debt, or other types of loans, but it does not remove back taxes or student loan debt.

The upside with bankruptcy is that it only takes a couple of months to complete versus debt settlement, which can take years to implement a plan. 

Working With a Debt Settlement Company

Debt settlement companies can provide you with an important service, but there are risks you need to know about before entering into an agreement.

  • They often charge expensive fees.
  • They will typically encourage you to stop paying your credit card bills, which can lead to credit impacts, added late fees, penalties, and other charges. These added costs may wipe out any potential savings on debt settlement. In some cases, you could wind up deeper in debt.
  • Some creditors will not work with debt settlement companies.
  • There’s a good chance a company won’t be able to settle all of your debts.
  • Working with a debt settlement company may lead to a creditor to file a debt collection lawsuit against you.
  • Ensure fees are structured as a percentage of debt eliminated rather than the balance when you enroll. That gives the company an incentive to trim more of your debt.

Before you do business with any debt settlement company, search the CFPB’s Consumer Complaint Database. You can also contact your state Attorney General and local consumer protection agency to see if any complaints about the firm are on file. 

Some states require debt settlement companies to be licensed. Check with your state regulator or ask your state Attorney General if debt settlement companies are required to be licensed to work in your state and if the company you want to work with is in good standing.

Kirk Haverkamp

Kirk Haverkamp is an award-winning reporter and editor with more than 25 years of experience in journalism and public relations. He has contributed to Credit.com, Investopedia, and MetroMode online magazines, among other work. He has a B.A. in English from Hope College and a Master’s Degree in journalism from Michigan State University.

Compare Today's Personal Loan Rates

View Rates