What Is Debt Settlement?

How Does Debt Settlement Work?

Debt settlement is the process of negotiating with your lenders to pay off your debt. While it's possible to negotiate settlement on your own—and could save you money—debt settlement usually refers to a service in which a company negotiates your debts for you. Settlement is sometimes also called debt relief.

First, the debt settlement company will typically instruct you to stop making payments to your creditors. This gives them leverage to negotiate your debts, as lenders may see settling as a preferable alternative to getting no payment at all.

Next, you'll likely be asked to deposit funds each month into a dedicated savings account set up for you. Once you've amassed sufficient funds, the settlement company will attempt to negotiate agreements with your creditors. Depending on how much debt you owe, it could take three or four years for the process to complete.

Note: Debt settlement companies are legally required to tell you upfront how much money you'll need to accumulate in the dedicated account before they'll begin to attempt negotiations with your creditors.

Learn more >> Is It Better to Pay Off Debt or Settle It?

Pros and Cons of Debt Settlement Companies

Before you consider debt settlement, balance the downsides against any potential benefits.

Pros

• Debt settlement may allow you to reduce your debt. If the debt settlement company successfully negotiates your debts, you may be able to get out of debt for less money. That said, you can't be sure settling will pan out beforehand, so it's a risky strategy.
• It may be easier than negotiating on your own. If your goal is to pay off your debts for less than you owe, you might find paying a company to negotiate for you easier than trying to negotiate with your lenders on your own.
• It could help you avoid bankruptcy. If successful, settling your debt could help you avoid bankruptcy. In some cases, the overall impact of settlement could be less severe than filing for bankruptcy (but this isn't guaranteed).

Cons

• It hurts your credit. Debt settlement companies often instruct you to stop making payments on your debts. This damages your credit score and leads to long-lasting negative entries on your credit report. This can make it difficult to qualify for new credit down the line.
• It could leave you in more debt than you started with. Your creditors may refuse to work with your debt settlement company. And by stopping payments, late fees will likely accrue on top of interest each month, leaving you with a growing balance.
• It can be expensive. Debt settlement companies typically charge around 15% to 25% of the debt you enrolled in the program. They may also charge you based on a percentage of the amount forgiven (or, the amount of the enrolled debt minus the amount you had to pay the lenders to settle the debt). You may be charged additional fees, such as a fee for the dedicated settlement bank account.
• Your forgiven debt is taxable. Debt relief can lead to a tax bomb. If your forgiven debt totals more than $600, the IRS considers it taxable income. So, for example, if you settled a $5,000 balance for $3,000, you'd owe income taxes on the $2,000 difference.

Learn more >> Tax Implications of Settling Your Debt

Is Debt Settlement a Scam?

Debt settlement is not necessarily a scam. But even working with a legitimate debt settlement company may not be a good idea. Debt settlement is inherently risky, and it can also be expensive.

That said, there are also debt settlement or debt relief scams that aim to steal your money or sensitive data. Here are some signs you're dealing with a debt settlement scammer:

• Unsolicited phone calls, texts or emails offering debt relief
• Instructions to pay fees before your debts have been settled (it is illegal for a company to charge you before they've settled your debt)
• Guarantees to settle all your debt by a promised amount (such as 50% less than what you owe)
• References to "new government programs" that will erase all your debts
• Promises to stop collection calls or lawsuits against you

Learn more >> Signs of Debt Settlement Scams to Watch For

Does Debt Settlement Hurt Your Credit?

Yes, debt settlement can hurt your credit. Payment history has the single largest impact on your credit. If you're considering debt settlement, you may already have overdue balances. And, once you begin the settlement process, the debt relief company will ask you to stop making payments to your creditors.

Missing a payment by 30 days can decrease your credit score, and the impact worsens as payments become 60 or 90 days past due. Over time, if you continue not to pay, some lenders may send your debts to collections. That leads to an additional negative entry on your credit report and a deeper impact on your score.

Learn more >> When Do Late Payments Get Reported?

Alternatives to Debt Settlement

Before you decide to pursue debt settlement, consider these other options.

Credit Counseling

A credit counselor can help you review your complete money picture to come up with a plan for how to meet your financial obligations, including getting out of debt.

In contrast with a for-profit debt settlement company, working with a certified credit counselor can give you the peace of mind that you're receiving financial advice to truly benefit you. Look for a credit counselor accredited by the National Foundation for Credit Counseling (NFCC) or the Financial Counseling Association of America (FCAA). They have strict standards for how credit counselors operate, including requirements that agencies provide you with clear information and act in your best interest.

Learn more >> How Does Debt Counseling Work?

Debt Management Plan

A debt management plan (DMP) is set up by a credit counselor and allows you to streamline your monthly payments, organize your finances and pay off what you owe. When you enter a DMP, your credit counselor may also be able to negotiate interest rate deductions or other forms of relief with your lenders.

Unlike debt settlement, DMPs are offered by nonprofit credit counseling agencies, and they're designed to help you pay off your unsecured debt (such as credit cards and personal loans) while minimizing harm to your credit.

That said, there are still a couple downsides to consider. First, you'll typically pay a setup and monthly fee for a DMP service. The charges may depend on the agency's policies and possibly your income. Second, when you participate in a DMP, you may be required to close the credit card accounts included in the program. Closing credit cards could push your credit utilization up, potentially lowering your credit scores.

Overall, when a DMP is a good fit, it may be able to help you improve your financial situation and boost your credit in the long run.

Learn more >> Debt Settlement vs. Debt Management: Which Is Better?

Debt Consolidation

Debt consolidation may be a good alternative to debt settlement, but it depends on your credit and financial situation. Debt consolidation works by using a personal loan to pay off other debts, ideally with a lower interest rate than the average rate of your current balances. Consolidating may allow you to turn multiple monthly payments into just one, which can make getting out of debt easier to manage.

You'll typically need good credit to qualify for a debt consolidation loan, so consolidation may not be an option if you have missed payments or a low score. Also, debt consolidation doesn't get to the root cause of your debts—sometimes, consolidation can even lead you further into debt.

Learn more >> Debt Consolidation vs. Debt Settlement

Bankruptcy

You might be considering debt settlement as a way to avoid bankruptcy. Bankruptcy causes greater harm to your credit than any other single event and should be considered a last resort. But, in some cases, bankruptcy may be a better option than settlement, especially if you have very few assets. Here's how the two compare:

• Both hurt your credit. Both bankruptcy and debt settlement result in negative credit events, and both can do significant damage to your credit score.
• Both appear on your credit report. Both bankruptcy and debt settlement result in lasting negative entries on your credit report. Chapter 13 bankruptcy remains on your credit report for seven years, and Chapter 7 bankruptcy remains on your report for 10 years. Debt settlement often results in missed payments, charge-offs and accounts in collections, which each also remain on your credit report for seven years.
• Both cost money. Bankruptcy is a costly legal process, and debt settlement also comes with fees. Depending on the specifics of your financial situation, bankruptcy could cost you less in the long run—especially if you qualify for Chapter 7 bankruptcy.

If your creditors refuse to work with your debt settlement company, you may still find yourself resorting to bankruptcy. By pursuing settlement first, you may only rack up additional interest and fees, plus sacrifice time that you could have spent financially recovering and rebuilding your credit.

The Bottom Line

While debt settlement may seem like a good option, you should consider alternatives first. The risks of settling your debt likely outweigh the benefits. Also, remember that you can negotiate with your creditors yourself, which could save you money.

If it's within your ability, continue to make minimum payments on your debts to preserve your credit and avoid fees. Then, consider reaching out to a nonprofit credit counselor to seek unbiased, personalized advice. They can help you review your options to ensure you're choosing a path that's best suited to your financial situation.