What is debt settlement?

You can negotiate with creditors to reduce what you owe, but it can be a risky approach

Author pictureAuthor picture
Author picture
Written by
Author picture
Edited by

Could your debt be reduced or forgiven? Take our financial relief quiz.

hand using calculator to compute costs

Debt settlement, also known as debt relief or debt resolution, involves reducing the amount of debt you owe to creditors.

“Debt settlement is akin to reaching a financial truce with your creditors,” explained Sumeet Kumar, a certified financial education instructor 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.”

It’s not an easy process, especially if you go the DIY route and negotiate on your own. However, there are also debt settlement companies that negotiate on your behalf — for a price, of course.

Key insights

  • Debt settlement companies provide relief for individuals with overwhelming debt by negotiating with creditors to lower the amount owed.
  • While benefits include debt reduction and avoiding bankruptcy, debt settlement also has drawbacks, such as a negative hit to your credit score and potential tax implications.
  • Alternatives to debt settlement are often better options and include solutions such as debt consolidation loans and debt management plans

How to settle debt

Debt settlement is a complex process. Lenders don’t want to settle for less than you owe them, so negotiations take time and a decent amount of money to complete.

The fee-free way of negotiating involves going it alone, but unless you have experience in tough negotiations, this can be intimidating. The other route is working with a debt settlement company. This is an easier but more expensive route.

Work with a debt settlement company

There are numerous reputable debt settlement companies willing to help, assuming you’re prepared to pay a fee. You’ll typically pay 15% to 25% of the debt — either the total debt owed or the amount settled for, depending on the company.

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

  1. Initial assessment with a financial counselor. The debt settlement company will connect you with a financial counselor. 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 you owe. They’ll keep you up to date on their dealings 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.

To avoid working with shady debt settlement companies, you should know the following about fees they charge:

  • Charging upfront fees is illegal. Debt settlement companies should never charge upfront fees. Only when you settle should you expect to pay.
  • The company must successfully negotiate your debt. The Federal Trade Commission (FTC) created a rule that specifically states the debt settlement company must reach a settlement to charge you fees.

» MORE: What is the Fair Debt Collection Practices Act?

Negotiate debt settlement on your own

Negotiating on your own may seem intimidating. After all, you have to deal with multiple creditors that are already on your back for missed payments. But it is possible to do it yourself and eliminate the cost of an intermediary having those hard conversations for you.

Generally, you’ll complete the following steps:

  1. Assess your own financial needs. Start by assessing your financial situation, including a list of your debts and your available resources. Go to negotiations with a realistic number of what you can afford each month. Try your best not to budge.
  2. Contact all of 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 written confirmation detailing the terms of the settlement and is 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.

» MORE: How to negotiate credit card debt

Benefits of debt settlement

For those in unbearable debt, settlement offers a lifeline that can lead to a brighter financial future. There are major benefits as long as the process goes according to plan.

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

Bankruptcy is one of the last resorts when you can’t get out of a bad financial situation. Debt settlement helps you avoid this option. 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.

Debt settlement is akin to reaching a financial truce with your creditors.”
— Sumeet Kumar, National Financial Educators Council

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 relief includes a reduction in the interest rates on your outstanding debts. Lower rates can significantly decrease the total amount you need to pay back, helping to ease your financial burden.

Drawbacks of debt settlement

Debt settlement sounds great on the surface, but there are many considerations to think about before jumping in headfirst. There are also potential negative consequences if the process isn’t successful.

Debt settlement companies typically charge 15% to 25% of the debt owed or of the amount settled for.

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 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.

Is debt settlement a good idea?

While all of us would love our debts lessened, debt settlement programs aren’t designed for all types of people. Here are situations where debt settlement makes sense:

  • You have significant, 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.

If you don’t fit the descriptions above, other alternatives are less risky and may work better. These alternatives won’t always result in settled debt, but they do make your debt more manageable.

  • Debt consolidation: Debt consolidation loans 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 that 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 card with a 0% introductory annual percentage rate (APR) helps you save on interest charges.

» MORE: How to get out of debt

Could your debt be reduced or forgiven? Take our financial relief quiz.


    What percentage should I offer to settle debt?

    The percentage you should offer to settle debt varies depending on the lender you’re working with. There’s no real average, but lenders often agree to 30% to 50% of the outstanding debt.

    Does debt settlement hurt your credit?

    Yes, debt settlement can, and often does, hurt your credit. When you settle a debt for less than the full amount owed, it typically results in a negative entry on your credit report. However, the impact on your credit can be less severe than a bankruptcy, and as you work to rebuild your finances, your credit score can gradually improve over time.

    How long does debt settlement stay on your credit report?

    Debt settlement entries can stay on your credit report for up to seven years from the date of the settlement. This can negatively impact your credit score during that time.

    How long does it take to rebuild credit after debt settlement?

    Rebuilding credit after debt settlement can vary from person to person. In general, it may take several years of responsible financial management, including timely payments, to significantly improve your credit score. However, you can start seeing some small improvements within a year or two if you consistently practice good credit habits.

    How long after debt settlement can I buy a house?

    The specific time frame for buying a house after debt settlement varies depending on other factors like your credit score, financial stability and lender requirements. In general, it may take at least a couple of years of responsible financial management and credit rebuilding after debt settlement to qualify for a mortgage — or at least a mortgage worth getting.

    Bottom line

    Debt settlement occurs when you successfully negotiate with creditors to lower your debt. While it can help individuals struggling with unmanageable debt, it's essential to weigh the pros and cons of debt settlement. On the positive side, debt settlement can lead to significant debt reduction and prevent bankruptcy. However, it also comes with a negative impact on your credit score, potential tax consequences and high fees.

    It's crucial to explore alternative options first and to consult with financial professionals to determine the best path based on your unique financial situation and goals. Ultimately, the decision should align with your goals for financial well-being and creditworthiness.

    Article sources
    ConsumerAffairs writers primarily rely on government data, industry experts and original research from other reputable publications to inform their work. Specific sources for this article include:
    1. Consumer Financial Protection Bureau, “ CFPB Takes Action Against Debt-Settlement Company for Charging Consumers Unlawful Fees .” Accessed Sept. 21, 2023.
    2. Consumer Financial Protection Bureau, “ How long does negative information remain on my credit report? ” Accessed Sept. 20, 2023.
    3. Federal Trade Commission, “ Debt Relief Services & the Telemarketing Sales Rule: A Guide for Business .” Accessed Sept. 21, 2023.
    4. InCharge Debt Solutions, “ Debt Settlement .” Accessed Sept. 20, 2023.
    5. IRS, “ Topic No. 431, Canceled Debt – Is It Taxable or Not? ” Accessed Sept. 20, 2023.
    6. FICO, “ What Are the Different Types of Bankruptcy and How Is Each Considered by My FICO Score? ” Accessed Sept. 20, 2023.
    7. Tayne Law Group, P.C., “ What Percentage Should I Offer to Settle Debt? ” Accessed Sept. 20, 2023.
    Did you find this article helpful? |
    Share this article