What Is Debt Settlement and How Does It Work?

Debt can be overwhelming, especially if it feels out of control. Maybe you owe more than you think you could ever repay, or your debts are past-due in collections.

Debt settlement may seem like a lifeline in these circumstances, but it’s risky, since it damages your credit, includes costly fees and can take years to complete.

Learn how debt settlement works and compare it with other debt payoff strategies, like credit counseling and debt consolidation.

Debt settlement is the process of negotiating down a debt to a lower amount than you owe and is usually done with the help of a third party, like a debt settlement company.

Once the creditor accepts the settlement, it can’t continue to hound you for the money, and you don’t have to worry that you could get sued over that particular debt.

Debt settlement gives you a plan for becoming debt-free, which can be a huge relief, but the process can take up to three to four years, and it isn’t always successful.

Debt settlement companies negotiate with creditors on your behalf to reduce the amount you owe on unsecured debt like credit cards, medical bills or personal loans. Debt settlement is not an option for secured debt, like a mortgage or auto loan.

These offers are only enticing to creditors if it seems like you won’t pay at all, so a debt settlement company will advise you to stop making payments on your debts immediately and instead open an escrow account and put a monthly payment there. Once you have enough money saved for a lump-sum offer, the settlement company facilitates the transaction.

Debt settlement isn’t free. Most companies charge a fee of 15% to 25% of the amount you owe. For example, if you owe $10,000, and the debt settlement company charges a fee of 25%, you’ll pay $2,500 once the settlement is complete (in addition to paying the settled amount to your creditor). A debt settlement company cannot collect this fee until it settles your debt.

The Consumer Financial Protection Bureau cautions consumers about debt settlement^[0]

• Your credit may take a hit: If you’re not already delinquent on your accounts, you will be once you divert debt payments toward the settlement account. Delinquent accounts and debt charged off by lenders stays on your credit report for seven years.

• Penalties and interest accrue: When you stop making payments on your debts, you’ll likely face financial penalties like late fees. You may also accrue interest, increasing the overall amount you owe. 

• You’ll have to pay a fee when a debt settles: Most debt settlement companies charge a percentage of each debt they settle, based on that debt’s balance when you enrolled in the program. Some charge a percentage of the debt eliminated by the settlement.

• You may pay other fees: In addition to the settlement fee, customers may have to pay other fees, such as a setup fee to open the dedicated escrow account and a monthly fee to maintain the account. 

• Forgiven debt may be taxable: The Internal Revenue Service generally regards forgiven debt as income. You may want to consult a tax professional about additional tax obligations you’ll be taking on if you settle your debt.

• There’s no guarantee of success: Debt settlement doesn’t always work. Not all creditors work with debt settlement companies, and even if they do, they may not accept the settlement offer. Depending on how long settlement takes, the fees and interest that accrue in the meantime may wipe out any potential savings.

Debt settlement can negatively impact your credit in several ways.

Missed payments to your creditors — which most debt settlement companies advise — will likely be reported to the credit bureaus. If you become significantly delinquent, you may be sent to a collections department or agency, which can further hurt your credit score.

Any settled debts ding your credit, since the creditor accepted less than what was owed.

These marks can stay on your credit report for up to seven years.

However, paying something is better than paying nothing at all. If the choice is between not addressing your debt or settling it, debt settlement may be the better option.

Not all debt settlement companies are reputable. Stay away from any company that tries to collect an upfront settlement fee or guarantees it can make your debts go away for “pennies on the dollar” or a promised reduction amount, says the CFPB.

Debt settlement companies shouldn’t advise you to stop communicating with your creditors. Until the debt is settled, settlement companies can’t stop debt collection calls or lawsuits.

Research any debt settlement company you’re considering. Check with the Better Business Bureau to see if there’s a history of complaints. Prioritize reputable companies that hold outside accreditations, such as from the American Association for Debt Resolution.

Finally, companies should be upfront about fees, terms of service, how long it will take to settle your debts and how much money you need to save before the company makes a settlement offer, according to the Federal Trade Commission^[0]

How to negotiate debt settlement on your own

You can try negotiating a settlement yourself, which saves money on fees and may help you get out of debt faster since you control the timeline.

Gather as much money as you can to make a lump-sum offer. This may mean taking a part-time job, selling valuable belongings or other quick ways to get cash.

Though some creditors may be likelier to take a lump-sum offer, which gives them money immediately rather than taking a chance on payments that might not come, other creditors may have a policy against settling debts.

Debt settlement isn’t the only way to get relief from overwhelming debt. Working with a reputable, nonprofit credit counseling agency is a safer alternative if you have credit card debt. Credit counselors can help you enroll in a debt management plan, which combines your credit card payments into a single payment with lower interest and gives you a plan to pay off the debt in three to five years. These plans typically come with a one-time setup fee and a small monthly service fee.

Another option is to take out a debt consolidation loan from an online lender or credit union and use the money from the loan to pay off all your debts at once. You then repay the loan at a fixed rate over a set term, usually two to seven years. These loans make the most sense if you can qualify for a lower rate than the average rate across your existing debts.

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