Debt settlement is when you negotiate with creditors to reduce the amount you owe in exchange for a lump sum payment. It might provide relief, but it comes with credit score impacts and tax obligations.
Debt settlement is a financial strategy that involves negotiating with creditors, with the help of a debt relief company or on your own, to reduce the total amount you owe. However, it should be a last resort because the consequences are severe and can stay on your financial record for years afterward.
Debt settlement generally shouldn’t be considered unless bankruptcy isn’t an option because of how severe the consequences of debt settlement are.
Why do people choose debt settlement – and should you?
Sometimes known as debt relief, debt settlement occurs when you and a creditor agree to settle debt for less than what you owe. That settlement can involve reducing the principal amount in exchange for a lump-sum payment to the creditor or decreasing the interest rate.
Debt settlement might be a good option if:
- You’ve struggled for a long time to pay down your debts.
- Your debts are past due and/or have been submitted to collections agencies. Creditors generally won’t negotiate until you’re at least 90 days past due.
- You’re suffering financial hardship and can’t pay what you owe.
- You can set aside money for a lump-sum payment.
- Creditors frequently harass you.
- Bankruptcy won’t help your situation.
Most settlement agreements won’t eliminate your entire debt. Furthermore, it isn’t a “quick-fix” process — a debt settlement can take years and still involves negative consequences even when successful.
What are the risks of debt settlement?
While debt settlement can be a helpful tool for managing overwhelming debt, it comes with significant risks that you should carefully consider before proceeding. Here are some of the primary risks associated with this approach:
- Creditor harassment and legal action. While you’re negotiating, creditors may continue to call, send notices or even file lawsuits to collect the debt. This can add stress to an already challenging situation.
- Emotional and financial stress. Debt settlement is often a long and difficult process, requiring persistence and emotional resilience. For some, the uncertainty and financial strain may outweigh the potential benefits.
- High fees from settlement companies. If you use a debt settlement company, you’ll likely pay fees ranging from 15 percent to 25 percent of the settled amount. These fees, combined with the impact of halting payments, may mean that the savings aren’t as significant as expected.
- Long-term damage to your credit score. By the time you’re eligible for debt settlement, your credit score is already bad. Settlement can prolong how long your credit is low. Missed payments and settled debts are reported on your credit report and can remain there for up to seven years, making it harder to obtain loans or credit in the future. Bankruptcy can help you resolve the situation sooner and start repairing your credit right away.
- No guaranteed outcome. There’s no guarantee that creditors will agree to settle your debt. Some may refuse your offer or demand a higher payment than you can afford. If negotiations fail, you’ll be further behind on payments with added late fees and interest.
- Risk of falling deeper into debt. If you’re unable to save the lump sum payment required for settlement or if negotiations take longer than a month or two (which they usually do), you could fall further into debt due to accumulating interest, penalties and collection fees.
- Tax implications. The IRS considers forgiven debt as taxable income. For example, if you settle a $10,000 debt for $6,000, the $4,000 forgiven may be taxed, adding to your financial burden. However, you may be able to avoid this tax in cases of insolvency.
Understanding these risks can help you decide whether debt settlement is the right solution for your financial challenges. Weigh the potential drawbacks against your goals and consider consulting a financial advisor or credit counselor for guidance.
How to do your own debt settlement
Taking charge of your own debt settlement can be a cost-effective way to regain financial control. While the process requires effort and persistence, following a clear strategy can increase your chances of success. Below are the key steps to handle debt settlement on your own.
Assess your financial situation
Before reaching out to creditors, it’s crucial to get a clear picture of your financial situation. Start by listing all your debts, including the creditor’s name, total amount owed, interest rates and payment status. Determine how much money you can realistically offer as a lump sum for each account.
Many creditors may be open to settling for 40 to 60 percent of the total owed, so use this as a guideline when determining your offer. Additionally, consider prioritizing which debts to settle first, such as those with the highest balances or those in collections.
Contact your creditors
Once you’ve assessed your finances, the next step is to contact your creditors directly. Start by calling their customer service line and requesting to speak with a representative who handles hardship cases or settlements.
Ask for a hardship plan first. Creditors are more likely to offer these, and hardship plans will be more likely to preserve your credit score. It’s best to talk to a creditor as soon as you think you may struggle to pay your bills.
Be prepared to answer questions about your income, expenses and why you’re struggling to pay.If there isn’t a hardship plan available or you are determined to negotiate a settlement, be polite but firm and explain your financial hardship clearly. Let them know you’re unable to pay the full amount but are willing to settle for a reduced lump sum payment.
Negotiate terms
Negotiating is the heart of the debt settlement process. Begin with a lower offer than what you’re willing to pay, giving yourself room to negotiate. For example, if you can afford 50 percent, start by offering 30 percent.
During negotiations, aim to secure favorable terms. Ask about any fees or tax implications. Once you reach an agreement, request a written confirmation of the terms before making any payments.
Make the payment
After finalizing the settlement agreement, follow the agreed-upon terms precisely, whether it’s a single lump sum or a series of installments. Use a secure method, such as a cashier’s check or electronic transfer, and keep records of all payments.
Once the payment is completed, verify with the creditor that the account has been closed and settled. Monitor your credit report to ensure the account is updated accurately.
By taking these steps, you can try to negotiate a debt settlement, reduce your financial burden and work toward a debt-free future.
How to work with a debt settlement company
If you know you’re a poor negotiator or don’t have the time or patience to deal with every creditor, another option is to work with a third-party debt settlement company. That company will contact creditors on your behalf and attempt to strike an agreement that works for both sides.
Reputable debt relief companies have the experience and know-how when working with creditors on debt settlements. However, they’ll have you stop payments if you’d previously been keeping up with them so the settlement company has something to negotiate with. Instead, they’ll direct you to put those payments into a special escrow account.
Once an agreement is struck, the debt settlement company will pay the creditors (and collect its fees) from the escrow account. Just as when you stop payments on your own, these missed payments will drop your credit score.
The debt settlement industry also attracts some bad actors. Be sure to take the following steps to verify you’re working with a dependable debt settlement company.
Research the company’s track record
Your target company should have been active for a while — years, if possible. Be wary of newer companies. Also, check out reviews, especially on third-party websites. Look for consistent critical comments about customer service, processes and resolutions.
Check out accreditations
There are numerous accreditations for debt settlement companies. The American Association for Debt Resolution audits members to ensure they follow regulations. Also, be sure your counselor is certified by the International Association of Professional Debt Arbitrators.
Know who you’re working with
When you ask a debt relief company about costs and the word “commissions” comes up, that could be a red flag. Commissions signify that your “counselor” is a salesperson who is likely in it for the money rather than to help resolve your debt. That’s probably not someone who will work in your best interests.
Ignore big claims
You might be listening to talk radio or watching late-night television when an ad appears. The ad promotes a debt settlement company that claims it can settle your debt for pennies on the dollar, stop harassing calls and guarantee a solution.
A trustworthy debt settlement company will only make such promises in light of your specific situation. If any company advertises this or approaches you with these “assurances,” ignore it and move on. And never pay an upfront fee before a company has done some work for you.
Alternatives to debt settlement
Debt settlement isn’t the only option for managing overwhelming debt. Depending on your financial situation, most alternatives may be more effective or less risky. Here are some common options to consider.
Debt management plan (DMP)
A debt management plan is a structured repayment program typically offered through credit counseling agencies. With a DMP, the agency works with your creditors to lower interest rates and consolidate your payments into one monthly amount. This option helps you stay organized and pay off your debts over time, usually within three to five years, without the negative impact on your credit score that comes with debt settlement.
Debt consolidation
Debt consolidation involves combining multiple debts into a single loan with a lower interest rate or more manageable monthly payments. You can achieve this through a personal loan, a balance transfer credit card or a home equity loan. While it doesn’t reduce the total amount owed, it simplifies repayment and can save money on interest. This option works best if you have a steady income and decent credit.
These options are generally only available to people with higher credit scores. If you suspect your debts may soon become unmanageable, it’s best to look into this option early.
Bankruptcy
Filing for bankruptcy is a legal process that provides relief from overwhelming debts, either by liquidating your assets (Chapter 7) or creating a repayment plan (Chapter 13). While bankruptcy can offer a fresh start, it has significant long-term consequences for your credit and financial stability.
However, compared to debt settlement, you can start rebuilding your credit right away instead of waiting months or years to try to fix things. Bankruptcy also guarantees lenders that you can’t file again in a certain period, unlike with debt settlement
Negotiating lower interest rates
If you’re struggling with high-interest debt and have good credit, consider negotiating directly with creditors to lower your interest rates. This can make monthly payments more affordable without needing to settle the debt for less than the full amount. A simple phone call explaining your financial hardship may result in better terms.
Increase your income or cut expenses
Sometimes, the best solution is to boost your financial capacity. Look for ways to increase your income, such as taking on a side job, freelancing or selling unused items. At the same time, evaluate your budget to identify areas where you can cut back on expenses. Using the extra funds to pay down your debts can help you regain control without resorting to settlement.
The bottom line
Debt settlement can help reduce overwhelming debt, but it’s not without risks. It’s possible to DIY debt settlement, though you may find using a debt settlement company to be an easier option.
If debt settlement feels right for you, start by assessing your finances and deciding whether to handle negotiations yourself or hire a reputable company. Stay persistent, understand the terms and ensure you’re prepared for potential credit impacts and tax obligations.
If settlement isn’t the best fit, explore other options to manage your debt, such as debt management plans, consolidation and even bankruptcy. The key is to take action, stay informed and commit to a plan that suits your situation.
Frequently asked questions
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Debt settlement will generally take longer, doesn’t eliminate all debt and still affects your credit score. It also may look riskier to creditors because you can only apply for bankruptcy again after a certain period of time. Bankruptcy may provide faster relief and a clean slate. Both will damage your credit score, but you can start rebuilding your credit faster with bankruptcy than you might if you drag out late payments and negotiations with debt settlement.
Consider consulting a financial advisor to determine the best option for your circumstances.
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It’s possible but less likely. Creditors are generally more open to settlement if your debts are delinquent or in collections. If you’re current on payments, they may prefer you to continue paying as agreed. However, if you’re facing financial hardship, explaining your situation and offering a settlement might still lead to a favorable outcome.
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No, debt settlement doesn’t eliminate all your debt. It reduces the amount you owe, but you’ll need to pay the agreed settlement amount. Additionally, settled debt is reported on your credit report for seven years and may be considered taxable income by the IRS, so you should prepare for these implications.
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