What is debt settlement?

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• A debt settlement will lower the amount of debt you owe your creditors.
• You can negotiate a debt settlement yourself, but hiring a debt settlement company gives you a higher chance of success.
• Debt settlement companies can be expensive, and you'll have to pay income tax on settled debt.

Negotiating a debt settlement with your creditors can significantly reduce the amount you owe. Debt settlement is a legitimate debt relief option if you're swimming in debt. However, it isn't a decision to take lightly. 

Debt settlement is a process that takes time and effort. Settling your debt through a third-party service can come with a hefty fee, and you may have to pay taxes on the amount you saved. Additionally, this process can severely hurt your credit score.

Debt settlement explained

Debt settlement is a debt relief program in which you negotiate with a creditor to reduce your debt if you pay a lump sum payment on the spot. 

You can take the DIY approach by negotiating directly with your creditor or debt collector to settle your debt. However, you'll need to be patient and determined during the process as the goal of a collections agent is to recoup as much of your debt as possible, says Natalia Brown, chief client operations officer at National Debt Relief. 

Alternatively, you can work with a debt relief company that will negotiate with your creditors on your behalf for a fee, usually as a percentage of the total enrolled debt. Going through a debt settlement plan will take significantly longer, generally around three to four years.

Working with a debt settlement company may increase the odds your creditors will agree to a debt settlement. "Debt settlement companies can leverage the power of their client base to help negotiate rates versus rates individuals acting on their own may receive," says Brown.

Under a plan offered by a debt settlement company, you stop paying your credit bills and deposit money into a savings account instead. Once you reach an amount the debt settlement company determines is adequate, they negotiate with your creditors for a lower debt amount. All that money you saved is then used to pay off the settled amount.

What types of debts can be settled?

You can settle most types of unsecured debt, like medical bills, credit card debt, personal loans, payday loans, business loans, and sometimes private student loans. 

You can't settle secured debt like mortgages or auto loans. You also can't settle federal student loans or tax debts. 

Debt settlement consequences

While debt settlements sound appealing, they are not without consequences. In fact, the process can even leave you in a less favorable position than you originally were. Understanding the drawbacks of this debt relief program can help you make the most informed decision and help you mitigate some of its negative impacts.

Lowered credit score

While paying off your debt usually results in a bump in your credit score by lower your credit utilization ratio and adding another line on your payment history, "you're not going to settle your debt and see your credit score jump up," says Rod Griffin, senior director of consumer education and advocacy at Experian. "Settling your debt doesn't remove it from your credit report."

Griffin explains that when creditors and debt collection agencies report your debt as settled, you may see a decrease in your credit score. The score reduction may not be as drastic as an account in collection, but the difference is marginal. Debt settlement may decrease your credit score and stay on your credit report for up to seven years from the debt's delinquency date.

Working with a debt settlement company can also affect your credit score. While the debt settlement company negotiates with your creditors, they may ask you to stop making payments on your accounts. The agency will ask you to do this so your creditors will be more inclined to settle your debt, and receive a payment, says Griffin. 

However, Brown explains that credit scores tend to go up after graduation from the program. While your credit is down, you should focus on paying off your debt rather than applying for a new line of credit. "When you're trying to get yourself out of debt, you shouldn't be looking to buy a new home or car, which is when credit scores really matter. Wait till you're out of the woods of debt with a stable credit score," says Brown.

High fees

Debt settlement companies may charge you 15% to 25% of the total amount you enroll with your debt settlement company. So, if the remainder of your debt amounts to $10,000, you may pay up to $2,500 in fees for that service. Griffin says that money could go toward paying down a portion of your debt instead of the debt settlement company.

If you opt to work with a debt settlement company, remember that it's illegal for companies to charge fees before successfully settling your debt, according to the Federal Trade Commission (FTC). Usually, you only start payments after establishing a plan and making your first payments.

Taxes on the settled debt

The Internal Revenue Service (IRS) considers your settled debt taxable income, so you may have to pay taxes on the forgiven debt. After you settle your debt, your creditor may send you a form 1099-C or the Cancellation of Debt form. Even if you don't receive this form, you must still report the settled amount on your tax returns.

How to find a debt settlement company

Being aware of debt settlement company red flags can help you avoid losing money to debt settlement scams.

Debt settlement companies must abide by guidelines set by the FTC. For starters, a company can't charge any fees before settling your debt, and they must disclose risks associated with debt settlement. 

Steer clear of companies that guarantee results and avoid answering your questions. "You can avoid debt settlement scams if no debt settlement company has given you a straight-up answer on how much you will owe them," says Brown. Unsolicited robocalls from a debt settlement company indicate that company is fraudulent.

You can determine a debt settlement company's legitimacy by verifying its status with the Better Business Bureau, American Fair Credit Council (AFCC), International Association of Professional Debt Arbitrators (IAPDA), or the Association of Settlement companies, says Brown. You can also check your state's attorney general's office and the Consumer Financial Protection Bureau (CFPB) to find a reputable organization.

 While you vet debt settlement companies, be sure to ask about costs, how fees will be paid, and the projected timeframe of its debt settlement program.

Alternatives to debt settlement

Debt settlement is one of many ways to crush your debt. However, it should be reserved for dire situations with no alternative. If you want to keep your credit score intact and avoid lofty fees, you may be interested in other debt relief programs.

Debt consolidation loan

Debt consolidation combines multiple high-interest debts into a single large debt. This relief solution makes your debt payments more manageable, and the best debt consolidation loans have lower interest rates than your current debts.

You do have to qualify for a personal loan to get favorable interest rates, which may only be possible if you have a good credit score. A debt consolidation loan will also result in a hard inquiry on your credit reports.

Balance transfer cards

Like a debt consolidation loan, a balance transfer card allows you to consolidate high-interest credit card debt onto another credit card. And like a debt consolidation loan, you will also incur a hard inquiry on your credit report when you apply for a balance transfer card. 

The best balance transfer cards have 0% introductory rates for the first 12-24 months and will waive balance transfer fees. You'll want to try and pay off as much of your debt, ideally all of it, within that introductory period. Once that promotional period ends, you will be charged interest on the outstanding balance.

Debt management plan

A debt management program helps you pay off unsecured debt and prepares you for financial success. 

A nonprofit credit counselor will evaluate your financial situation and determine the proper course of action. If your credit counselor determines that a debt management plan suits you, they'll work with your creditors to reduce your interest payments, waive late fees, and reduce your monthly payments in exchange for longer payment terms. Your credit counselors will require you to make a monthly payment, which they will disburse across your accounts.

Unlike debt settlements, a debt management plan doesn't change the amount you owe, just how you pay it. Debt management plans generally also take longer than debt settlements; however, your credit score won't suffer in the process. In fact, it will likely increase as you continue to make your debt payments.  

Is debt settlement right for you?

Debt settlement may be the right tool for some, but for many, it isn't, says Griffin. 

Griffin suggests that debt settlement may be appropriate if you struggle to repay your debt on a single account. Settling your debt on one account may hurt your credit score, but it won't do as much harm as settling debt on multiple accounts. That said, most debt settlement companies will only accept you as a customer if your debts exceed $10,000.

If you have multiple debts and anticipate challenges in paying those debts off, speak to your creditor about alternative repayment plans. A nonprofit credit counselor can also help you choose the right debt relief program for your situation, says Griffin. They usually offer free a consultation.

Consumers with large amounts of unsecured debt, who struggle to make their minimum monthly payments and are on the verge of bankruptcy, may benefit from a debt settlement program. However, if you have secured debts, can afford the minimum monthly payments, and are at risk of being sued by creditors or debt collectors (debt settlement doesn't offer legal protection), consider pursuing an alternative debt relief program, says Brown.

Debt settlement frequently asked questions (FAQ)

Is it worth it to settle debt?

Debt settlement should be your last resort, as it can significantly damage your credit score. This program may be worthwhile to borrowers with a single outstanding debt payment, as settling debt on one account may impact your credit score less than settling debt on multiple accounts.

What percentage do debt collectors settle for?

Consumers generally save 30% on their original debt amount with a debt settlement program, according to the American Fair Credit Council. 

What happens when a debt is settled?

Once your debt is settled, your debt collector will report your account as settled or partially paid, which stays on your credit history for up to seven years. While a debt settlement doesn't look great on your credit report, it's much better than an unpaid debt.