What Is Debt Settlement?

How debt settlement works

Debt settlement is when you negotiate the amount of debt you owe to creditors. It’s generally a complex process since lenders don’t want to settle for less than what you owe them, so negotiations take time and a decent amount of money to complete.

“Debt settlement is akin to reaching a financial truce with your creditors,” said Sumeet Kumar, a certified financial education instructor (CFEI) at the National Financial Educators Council. “You're essentially brokering a deal to pay a reduced lump sum, which, while less than what you owe, is accepted as full payment.”

Benefits of debt settlement

There are some benefits to debt settlement, such as:

Results in debt reduction

Debt settlement often results in a significant reduction in the total amount of debt you owe, saving you from a perpetual debt cycle. By negotiating with creditors or collection agencies, you can potentially settle your debts for less than the original balance.

Helps you avoid bankruptcy

Debt settlement helps you avoid bankruptcy, which is typically a last resort if you can’t get out of a bad financial situation. Bankruptcy can have long-lasting negative effects on your credit score and financial future.

Faster debt resolution

Compared with making minimum payments or struggling to pay off debts in full, debt settlement offers a faster path to debt resolution. However, you’ll need to have the money upfront to make a lump-sum payment.

Simplified repayment

With debt settlement, you consolidate your debts into a single lump-sum payment or a few manageable settlements. This makes the repayment process easier and helps you better manage your budget.

Helps eliminate collection calls

Once you've entered into a debt settlement agreement, collection calls from creditors and collection agencies typically cease.

Potential for an interest rate reduction

In some cases, debt settlement can include an interest rate reduction on your outstanding debts. Lower rates can significantly decrease the total amount you need to pay back, helping to ease your financial burden.

» MORE: Debt settlement pros and cons

Drawbacks of debt settlement

Debt settlement has some drawbacks, such as:

Negative impact on your credit score

As you negotiate to settle debts for less than the full amount, creditors may report these settled accounts as settled or charged-off, meaning you didn’t fully fulfill your loan obligations. This can lower your credit score and make it harder to secure future credit.

Creditors don’t need to agree

Just because you use a debt settlement company or negotiate on your own doesn’t mean a creditor needs to settle your debt. Some creditors may be unwilling to negotiate.

Taxes on debt settlements

Debt that’s forgiven through settlement can be considered taxable income by the Internal Revenue Service (IRS). This means you may owe taxes on the amount of debt that was forgiven, which can create an unexpected tax liability.

High fees and costs

Debt settlement companies often charge fees for their services, which can eat into the savings. Additionally, if you choose to negotiate on your own, you may still incur costs related to mailing, phone calls and any legal advice you seek.

How to settle debt with a debt settlement company

Working with a debt settlement company can help you negotiate your debt, though doing so will cost more than doing it yourself. Typically, you’ll pay 15% to 25% of the debt, either the total debt owed or the amount settled for.

If you choose to work with a debt settlement company, the process will likely look something like this:

1. Initial assessment

The debt settlement company will connect you with a financial counselor for an initial assessment. During your first meeting, you'll provide details about your financial situation, including your debts, income and expenses.

2. Create a payment plan

The company works with you to determine a monthly payment plan that you can afford. They’ll hold this payment in a dedicated account.

3. Stop payments to all creditors

Instead of paying your creditors directly, you'll stop making payments to them, and the funds will accumulate in the dedicated account.

4. Negotiation

The debt settlement company will negotiate with your creditors to reach settlements, hopefully for less than the full amount that you owe. They’ll also keep you up to date on their negotiations with the creditors.

5. Reach a settlement

When you reach an agreement, the funds in the dedicated account get used to pay the settled amounts to your creditors.

How to negotiate debt settlement on your own

Negotiating on your own may seem intimidating, but it’s possible to do it yourself. Generally, you’ll complete the following steps:

1. Assess your financial needs

Start by assessing your financial situation. Make a list of all of your debts and your available resources. This will help you to go to negotiations with a realistic number of what you can afford each month.

2. Contact your creditors

Reach out to each creditor directly to explain your financial hardship and ask about the possibility of debt settlement. Be prepared to provide documentation of your financial situation.

3. Negotiations

Negotiate with your creditors to arrive at a mutually acceptable settlement amount. They likely won’t offer you the first number you throw at them, so start low and stand firm.

4. Get agreements in writing

If you reach an agreement, ensure that you receive a debt settlement letter. This is a written confirmation detailing the terms of the settlement, and it’s important if there’s any confusion or legal trouble at a later date.

5. Make a lump-sum payment

Fulfill your end of the agreement by making the agreed-upon payment to your creditors.

» RELATED: How to negotiate credit card debt

Is debt settlement right for you?

Here are some situations where debt settlement can make sense:

• You have significant and overwhelming debts. Debt settlement is most effective for unsecured debts, such as credit card debt, medical bills or personal loans, which creditors may be more willing to negotiate.
• Your debt is making you struggle financially. If you're unable to make minimum payments and your debts are preventing you from paying other bills, debt settlement can provide a way to reduce your debt burden and regain financial stability.
• You want to avoid bankruptcy. Debt settlement is a bankruptcy alternative and may be a preferable option if you wish to avoid the long-term credit consequences of bankruptcy.
• You can afford to settle. Settling your debts requires a lump-sum payment to have your debts fully cleared. If you have access to funds or assets that can be used to make this payment, debt settlement may work.

Alternatives to debt settlement

There are some alternatives to debt settlement that are less risky and may work better, though most alternatives focus on debt management rather than settlement.

• Debt consolidation: Debt consolidation loans can help you combine multiple debts into a single, manageable loan with a lower interest rate.
• Credit counseling: There are nonprofit credit counseling agencies that offer free financial education and paid debt management services.
• Debt management plans: Credit counseling agencies offer debt management plans, which can help you create a structured plan to pay off your debts. These plans often come with reduced interest rates and fees, making your debts more affordable.
• Balance transfer credit cards: Transferring high-interest credit card balances to a balance transfer credit card with a 0% introductory annual percentage rate (APR) helps you save on interest charges for up to 21 months.

» MORE: How to get out of debt

FAQ

Bottom line

Debt settlement occurs when you successfully negotiate with creditors to lower your debt. While it can lead to significant debt reduction and prevent bankruptcy, it also negatively impacts your credit score and has potential tax consequences and high fees. It's crucial to explore alternative options first and to consult with a financial professional or credit counselor to determine the best path based on your unique financial situation and goals.