What is Debt Settlement?

Key takeaways: 

• Debt settlement is the act of negotiating with your creditor or lender to settle your debt for less than the total amount owed.
• There are several risks associated with settling debt including fees, damage to your credit score, and the possibility of getting taxed. 
• Debt settlement isn’t the only way to resolve debt. Other options include debt consolidation, credit counseling, and bankruptcy.

If you have a considerable amount of debt and the payments are getting hard for you to handle, you may think about debt settlement. While this debt repayment option can help borrowers settle their debt for less than they owe, it can come with some significant risks.

In fact, debt settlement could harm your credit score or lead to more debt. Before you commit, learn more about how debt settlement works, its pros and cons, and alternative options. 

Pro tip: Not all types of debt, like student loans, are eligible for debt settlement. 

Debt settlement meaning

Debt settlement, also known as debt relief or a debt adjustment, is the process of negotiating with a lender or debt collector to try to settle your debt for less than you owe. Borrowers typically work with a debt settlement company to help them through financial hardship, but it’s also something a person can do on their own.

If your lender agrees to a debt settlement, you’ll be required to make a single lump sum payment. This option is commonly used as a last resort alternative to bankruptcy. 

How does debt settlement work?

As we previously mentioned, you can negotiate a debt settlement yourself or you can use a third-party company. Negotiating your settlement without a debt settlement company can help you avoid unnecessary fees and settle your debts sooner.

A debt settlement company will negotiate with a lender or creditor on your behalf to lower or eliminate your debt. While it may be helpful to have an expert guide you through the debt settlement process, it’s important to note that you ‌need to pay for their services. 

Depending on the company, you’ll either pay a flat fee or they’ll take a percentage of the money they help you save. Even if your debt is settled for less than what you owe, you still have to set aside enough money to pay the company.

Usually, you’ll be required to make payments to the debt settlement company once they start negotiating with your lender. The company will use these funds to pay down your debt or to collect the money they’re charging you for their services. 

To be clear, a debt settlement agreement doesn’t mean your debt will be erased. Your settlement will likely be one of three options: a reduced amount ‌you pay in a lump sum, a lower monthly payment, or a debt discharge. 

Once the debt negotiations are settled, you will need to review and agree to the new terms to move the settlement forward. After you agree, you’ll make payments to the debt settlement company until your debt has been paid off.

Debt settlement pros and cons

Even though there are some benefits of debt settlement, there are several key risks you need to consider before you move forward with this option.

Benefits of debt settlement

• You’ll owe less: If an agreement is made, your debt will be reduced, and you won’t have to pay off your full balance.
• It may be more affordable: Debt settlement may be a cheaper and more effective option compared to credit counseling.
• You could avoid a potential lawsuit: If the settlement is successful, you won’t be at risk of a lawsuit from your lender or creditor.

Risks of debt settlement

• You could face hefty fees: A debt settlement company may charge fees for their services. In some cases, a third-party settlement company may charge you up to a quarter of the total debt amount. To put it into perspective, if you are looking to settle a $40,000 debt, you will pay a fee on the full amount, not the amount the original debt was negotiated down to. However, many lenders will work with borrowers directly for a settlement.
• It can damage your credit score: A debt settlement can have a negative impact on your credit score. Debt settlement companies typically advise borrowers to stop making payments on their credit cards during negotiations, since lenders are less likely to grant a settlement to a borrower who is still making their monthly payments. However, missed payments damage your credit.

Pro tip: When you settle a debt, the account will be marked as “settled” on your credit report for up to seven years. Lenders tend to view lenders with these types of marks as risky, which can make it hard to qualify for a loan or a line of credit.

• You may get taxed: If your debt settlement is successful, your relief could be short-lived since you may get taxed. Any forgiven debt that’s $600 or more is taxable, which means you need to pay taxes to the IRS on the amount you save.
• A settlement may not work: Debt settlement doesn’t always pan out. If you don’t receive a debt settlement offer, you’ll be responsible to pay for your debt plus any interest or late fees that may have accrued.

Alternatives to debt settlement

When it comes to your finances, it’s important to make the best decision about your unique financial situation. If you decide that debt settlement isn’t right for you, there are additional options. These include:

Credit counseling

A nonprofit credit counseling agency can offer free or low-cost budgeting and debt management advice. Credit counseling agencies rarely negotiate to settle debt, but a credit counselor will partner with you to create a debt management plan. Additionally, they may work with creditors or a collection agency to create a payment plan, prevent late fees, or stop efforts like collection calls.

Debt consolidation 

Debt consolidation is a method you can use to combine your debts into a single payment. Two common ways you can consolidate debt are with a debt consolidation loan or with a balance transfer credit card.

• Debt consolidation loan: A debt consolidation loan is a type of personal loan you can use to merge several debts into one loan payment. Since debt consolidation loans commonly have fixed interest rates, the monthly payment stays the same throughout the repayment period.
• Balance transfer credit card: With this type of card, you can simplify your loan payments by merging your debts onto a card with one monthly payment. If it’s available, consider a balance transfer credit card with a promotional 0% interest rate. That way, you can save money on interest if you pay off the balance before the promotional period ends.

Bankruptcy

Bankruptcy is typically used as a last resort, but it can be a good option for some. Filing for Chapter 7 bankruptcy will remove credit card debt, medical debt, or other types of debt. However, it doesn’t work for back taxes, student loan debt, or child support. 

Neither debt settlement nor bankruptcy is a great addition to your credit report, but bankruptcy is generally a quicker process. If you’re in a bind, bankruptcy may be a better option for you compared to a debt settlement.

Watch out for debt settlement scams

While most debt settlement companies will look out for your best interest, some companies are scams. When you research debt settlement programs, be on the lookout for:

• False promises: The Federal Trade Commission (FTC) advises borrowers to be weary of big promises that seem too good to be true. These kinds of promises include being able to erase your debt, or stopping debt lawsuits and collections. Remember, debt settlement isn’t a guarantee since creditors are not required by law to agree to a debt settlement. 
• Upfront fees before beginning debt settlement: Debt settlement services should not require you to pay any fees before they negotiate your settlement. If they do, research the company to make sure it’s legitimate and pay close attention to the fine print to make sure you’re not getting swindled.
• Lack of transparency: Your debt settlement company should advise you about any risks involved in debt settlement and the possible consequences of not making payments to your debt collectors. If they don’t take the time to make you aware of potential risks, that’s a red flag.

Is debt settlement worth it?

Debt settlement can be a good option for some people, but it’s not for everyone. Plus, some lenders won’t work with debt settlement companies, and some don’t do settlements at all. The best approach is to research all of your options before committing so you can make an informed decision. If you do commit to an option and it doesn’t work out like you thought it would, don’t be afraid to change course.