What Is Debt Settlement and How Does It Work?

Having debt you can’t pay off can be overwhelming and harmful to your credit. Debt settlement may be an option if you’re behind on payments and can’t afford to pay the full amount. By negotiating with creditors, you could reduce what you owe and start a path toward financial relief.

But debt settlement isn’t a quick or easy fix. It can take time, impact your credit, and may require costly fees if you use a company to do it for you. Learn how the process works, its potential benefits and risks, and possible alternatives to decide whether it’s the right choice for your finances.

What is debt settlement?

Debt settlement is a process involving a third-party company that negotiates your debt with creditors. The goal is for you to pay less than the full amount of debt you owe. It usually involves unsecured debts, like credit cards and medical bills, rather than secured debts, like mortgages or car loans. Some people use debt settlement as an alternative to debt consolidation loans, which can sometimes be difficult to qualify for if you have a low credit score or limited income.

Debt settlement can help you reduce debt and avoid bankruptcy. But it can take three to four years to settle your debts, and there’s no guarantee that a company can settle any or all of your debt. It can also be expensive because companies often charge fees for debt settlement. Additionally, missed payments and settled accounts can damage your credit score.

How does debt settlement work?

When you work with a debt settlement company, the company will usually tell you to stop making payments to your creditors. This helps the debt settlement company negotiate your debts, as many creditors won’t negotiate unless you’re behind on payments.

You’ll make monthly payments to the debt settlement company rather than to your creditors. The money goes into a dedicated account to build up a settlement fund. The debt settlement company offers the money in a dedicated account to attempt to settle with your creditors. 

This process can take months or several years, depending on how much debt you have. During this time, interest and late fees could still accrue on your unpaid accounts and increase your balances.

Creditors aren’t required to agree to any settlements from the debt settlement company. Instead, they could pursue legal action against you or transfer your account to a debt collection agency.

Debt settlement vs. debt management plan

Debt settlement and debt management plans (DMPs) can both provide debt relief, but they differ in how they work. 

Debt settlement’s primary focus is lowering the amount of debt you owe, while a DMP aims to help you pay off your debt in full but with more manageable payments and terms. A DMP might be able to lower your interest rates or monthly payments, for example. You would make one monthly payment toward your DMP rather than paying creditors separately, but unlike debt settlement, your creditors still receive continuous payments through the DMP.

Say you have $10,000 in credit card debt and can’t keep up with your monthly payments.

• Debt settlement company: You stop paying your creditors. Instead, you save money in a dedicated debt settlement account until a settlement amount is negotiated. Then, the debt settlement company uses the funds in the account to pay a lump sum to your creditors. If the creditors agree to settle for, say, $6,000 total, that (plus the debt settlement company’s fee) is all you would need to pay. But since you stop paying on your accounts (in order to make a settlement offer more attractive to creditors), you could severely harm your credit.
• Debt management plan: A credit counselor with a nonprofit credit counseling agency negotiates with your creditors to lower your interest rates and possibly reduce fees, thereby reducing the size of your payments. Instead of paying creditors directly, you make monthly payments to the credit counseling agency, which splits the payment among your creditors until you pay off the balances.

Both services charge fees, although DMP fees are typically much more affordable. With a DMP, expect to pay a one-time setup or enrollment fee between $30 and $75 and a monthly fee of $25 to $35. Debt settlement companies usually charge 15% to 25% of the amount they settle.

Read More: Debt Relief Programs: Options to Reduce Debt

Pros and cons of debt settlement

Debt settlement can help you get your debt under control, but it comes with risks that could have long-term effects on your credit and finances.

Pros

• Reduce what you owe: Debt settlement lets you negotiate with creditors to pay less than your full balance, potentially saving thousands of dollars.
• Avoid bankruptcy: Settling your debt could help you avoid bankruptcy.
• Choose which debts to enroll: You don't need to enroll all debts with a debt settlement company. “Many people have at least one credit card they think is manageable or has a low balance, so debt settlement allows you to try to keep that account open,” says Ashley F. Morgan, attorney and owner of Ashley F. Morgan Law, PC, a law office focused on bankruptcy and debt management solutions.
• Provides you with an advocate: If you don't like negotiating or lack expertise in financial matters, a debt settlement plan lets professionals negotiate on your behalf.

Cons

• No settlement guarantees: Creditors aren't obligated to accept a settlement offer from you or a debt settlement company. There's no guarantee debt settlement will work.
• Potential for charge-offs and legal consequences: Stopping payments during debt settlement can lead to legal action or debt collection if your debt goes unpaid for too long.
• Collector calls: If you want to avoid calls from creditors and collection agencies, debt settlement may not be for you. Since the process hinges on your accounts becoming delinquent, you could be contacted regularly until a settlement is reached.
• Costly fees: It's free to settle debts on your own, but debt settlement companies often charge 15% to 25% of your settled debt, as well as administrative fees.
• Can impact credit: Missed payments and settled accounts can appear as negative marks on your credit report and lower your credit score for up to 7 years, which could make it tough to qualify for new credit.
• Tax consequences: “Any debt that is forgiven can be considered taxable income,” warns Morgan. This could affect how much you owe in taxes.
• Lengthy process: Debt settlement typically takes 3 to 4 years.

How to negotiate debt settlement on your own

Negotiating and settling debt yourself can help you avoid the fees debt settlement companies charge.

To prepare, open a separate bank account for any money you want to put toward settlements. “You also want to budget in a buffer,” says Morgan. “If you expect your creditors to accept a 50% settlement, you want to budget around having 60% to 65% of the balances in funds to ensure that you can handle any settlements that are higher than anticipated.”

Follow these steps to negotiate a settlement:

1. Assess your debt: List your debts and the length of time they've been past due. Creditors may be more likely to settle older, delinquent accounts, particularly those that may be approaching the statute of limitations for legal action.
2. Decide what to offer: Calculate what you can reasonably afford. This way, you'll know the budget you need to stick to when you're ready to negotiate.
3. Contact your creditors: Explain your financial hardship and your suggested settlement amount to your creditors. Document all communications.
4. Agree in writing: If a creditor agrees to settle your debt, request a written agreement with all negotiated terms. Confirm that the creditor will report your on-time payment to at least one credit bureau.
5. Pay your settlement: Make your payment on time and keep a record of any payments made to creditors.

Types of debt settlement companies

Debt settlement companies are generally for-profit, but some nonprofit organizations might offer limited forms of debt settlement for lower fees and with less risk. For example, InCharge Debt Solutions, a nonprofit credit counseling agency, has a credit card debt forgiveness program with monthly payments rather than a lump-sum settlement. But debt relief programs and “debt settlement” available through nonprofit organizations may be just another name for that agency’s debt management programs.

How to choose a debt settlement company

Knowing what to look for in a debt settlement company can help you find a reputable service and avoid scams. 

“Choosing a debt settlement company is a lot like buying a new car,” says Howard Dvorkin, a CPA, debt solutions author, and the founder and chairman of Debt.com. “You research price, reliability, and safety.”

Steer clear of unreasonable promises, like guaranteeing to wipe out your debt. Legitimate companies acknowledge that results vary for each person.

Before you commit to a for-profit debt settlement company, search for agencies approved by the National Foundation for Credit Counseling or the Financial Counseling Association of America for guidance from a licensed credit counselor. These organizations connect you to agencies with free consultations and recommendations unique to your financial situation. There may be other options available to you besides debt settlement.

Debt settlement alternatives

Debt settlement isn’t the only way to manage overwhelming debts. Here are a few additional options.

Pay off your debt

There are many ways to pay off debt, so it’s possible that you just haven’t found the right solution yet. 

One way is the debt avalanche method. List your current debts, placing them in order from highest interest rate to lowest interest rate. Pay as much as you can — preferably more than the minimum payment — on the highest-interest debt each month while making minimum payments on your other debts. Once you pay off the highest-interest debt, move to the next-highest on the list and continue until you’ve paid off each debt.

There’s also the debt snowball method, which focuses on paying off your smallest debts first rather than high-interest debts. The debt snowball can be a better option if you are motivated by paying off a debt quickly, while the debt avalanche is recommended for people with high-interest loans who want to save money on interest.

Morgan also suggests contacting your credit card companies if there are one or two accounts you’re having difficulty paying. “Many credit card companies consider lowering interest and payments if you close your account,” says Morgan. “It isn't lowering the balance but does tend to make the debt more manageable.”

Use a credit counselor

A credit counselor can provide an unbiased review of your credit and debts to help you solve your underlying financial problem. You can work with one to create a DMP, solidify a budget, or get financial advice. Plus, says Dvorkin, “If they suggest debt-busting plans that come with fees, the law requires them to spell it out and not pressure you into doing anything that isn’t right for you.”

Get a debt consolidation loan

A debt consolidation loan pays off multiple debts, allowing you to make one monthly payment toward your loan rather than several debts. 

For a debt consolidation loan to save you money, it should have a lower annual percentage rate (APR) than the average weighted APR of your included debts. Here’s how to find your average weighted APR:

1. Add the balances of your debts.
2. Multiply each balance by its APR. 
3. Add the products together.
4. Divide that number by the sum of your debt balances.
5. Multiply this number by 100 to find your average weighted APR. 

But in some cases, a loan with an equivalent APR and longer repayment term could lower monthly payments — giving you breathing room to improve your credit and later refinance your debt to a lower rate.

Learn more: Debt Consolidation vs. Debt Settlement: Which Is Best for You?