Skip to Main Content

What is debt settlement and what are the risks?

Woman looks concerned while working on laptop
Iakov Filimonov/Shutterstock

At Bankrate we strive to help you make smarter financial decisions. While we adhere to strict , this post may contain references to products from our partners. Here’s an explanation for

Debt settlement is the process of negotiating with your creditors. You can do it yourself — or pay a third-party company to do it for you. It can be worthwhile for some, but debt settlement has its share of risks. Your credit score will almost certainly take a hit. Most importantly, your creditors may not agree to settle, leaving you with the same amount of debt as when you started.

What is debt settlement?

Debt settlement is when your debt is settled for less than what you currently owe, with the promise that you’ll pay the amount settled for in full.

Sometimes known as debt relief or debt adjustment, debt settlement is usually handled by a third-party company, although you could do it by yourself. Not all lenders accept debt settlements, and there are some instances where it could cause more financial harm than good.

What is a debt settlement company?

A debt settlement company acts as a middleman between you and your lenders and creditors to reduce or eliminate your debt. Sometimes it can be helpful to have an experienced guide to help you through an unfamiliar process.

But before working with a debt settlement company, understand its process and read reviews about the company. Different debt settlement companies offer different terms, so be sure to do your research.

How does debt settlement work?

You can settle your debt by yourself. Reach out to your creditors and explain your financial situation. It will take time and persistence, but you may be able to lower the amount you owe, change your interest rate or come to another form of agreement. While you and your creditors find a solution, you will continue to make the payments you owe.

If you opt for a third-party company or a lawyer, you will need to pay for their services as a flat fee or a percentage of your savings. This means that even if your debt is settled for less than what you owe, you still have additional costs outside your outstanding debt.

The debt settlement company will require you to stop paying your creditors and make payments into a savings account. That means depositing regular amounts into an account the company can use to pay your debt or collect the fees you owe. You may fall further behind on payments, and your credit score could plummet.

You will need to agree to the new terms if a settlement is reached — a lump-sum reduced amount, a lower monthly payment or a debt discharge. This needs to happen for settlement to move forward, but you’re not obligated to agree to any terms if you don’t want to. Depending on how the debt was settled, you may need to make payments to the company handling your debt until your outstanding debt is paid in full.

Risks of debt settlement

Debt settlement may seem like a convenient option, but the process has quite a few risks. In addition to finding a legitimate debt settlement company, you may need to wait years for your debts to be negotiated. Even if you do it yourself, you may not be able to avoid fees or a hit to your credit score.

You could face hefty fees

The fees associated with debt settlement services vary depending on local and state laws. It is not unusual for a third-party debt settlement professional to charge between 15 percent to 25 percent of the debt that gets resolved. That means if you’re seeking to settle a debt of $50,000, you’ll pay a fee based on that amount, not on the final negotiated repayment amount.

However, according to rules enacted by the Federal Trade Commission (FTC) in 2010, debt negotiation companies may charge fees only after they have resolved the debt for the client. Any debt settlement company or attorney that tries to charge you before the debt is settled is not legitimate. Avoid working with them; instead, find a reputable debt settlement professional who follows regulations.

Your credit score may be damaged

Going through the settlement process and resolving debt using this approach will likely negatively impact your credit score.

For instance, many debt settlement companies ask that you stop making payments on your credit card during negotiations. Lenders and creditors are not as likely to negotiate with consumers who can still make monthly payments on their bills. Not paying bills, of course, damages your credit.

“To settle, most creditors require that an account is in a delinquent status,” says debt attorney Leslie Tayne, founder of Tayne Law Group. “During the settlement process, an individual’s credit score will often take a hit while the accounts are in negotiation. This means you may also be sued.”

In addition, when accounts are marked as “settled” on credit reports, it can hurt your credit score.

Debt settlement is not as quick as you think

It is not unusual for the entire debt settlement process to take three to four years. Your attorney or debt settlement company will need time to negotiate with your creditors. The more creditors you have, the more time it will take. In addition, you will need time to build up the money in a savings account to pay off your debts in a lump sum.

Debt settlement is a long process. Expect for it to last years whether you work by yourself or with a third party. Patience is key, but it may make sense to consider some alternatives to debt settlement if you need relief from your debt sooner.

The forgiven debt is taxable

While it may be a relief to settle your debt, and possibly for less than you originally owed, you may now be on the hook with the IRS. Any forgiven debt over $600 is taxable. So, if a debt settlement company can negotiate $10,000 worth of debt down to $7,000, you will owe taxes on the $3,000 forgiven by your creditor.

Ideally, the money you pay your debt settlement company should also be enough to cover applicable taxes. However, you will need to check the fine print of any agreement you sign. If taxes are not included, you will be responsible for paying the remaining debt, the debt settlement company’s fee and the taxes.

You may owe more than when you started

When you begin the debt settlement process, the debt attorney or third-party company will often advise you to stop making payments on your debt. Interest will still accrue on that debt.

You may also begin racking up late fees and other charges. Ultimately, these charges may increase your debt to more than was originally owed. This could add complexity to your settlement and result in you not getting the relief from debt you expected.

You may not be able to settle

Not all companies will settle your outstanding debt. And even if they do agree to settle, some refuse to work with debt settlement companies. If you’ve agreed to follow the debt settlement company’s terms and haven’t been keeping up with your payments, this could make it more difficult to come to an arrangement with your creditor. Worse, your creditor may pursue legal action against you, incurring more costs and further harming your credit.

Alternatives to debt settlement

If debt settlement doesn’t work for your scenario, you have other options.

Bankruptcy

Bankruptcy is usually considered a last resort, but depending on your circumstances, it may be a more attractive option.

Filing for Chapter 7 bankruptcy will remove most outstanding debt, like credit cards, medical debt or other types of loans, but won’t remove back taxes, student loan debt or child support. This type of bankruptcy can take a few months to complete, compared to a few years with debt settlement. Neither option looks great on your credit report, but the sooner you remove or settle your debt, the sooner you can move on. If you want something faster, bankruptcy might be better than debt settlement.

Debt consolidation

Debt consolidation is when you combine all your debt into one new loan to pay off. It can reduce the amount of outstanding interest you owe and lets you make one manageable payment per month rather than many.

You can use a nonprofit credit counseling agency to help you through debt consolidation or go through it on your own using a debt consolidation loan.

Credit counseling

A nonprofit credit counseling agency can help you come up with a debt management plan that allows you to pay off your debt in circumstances that work best for your finances. Sometimes, credit counseling agencies will work similarly to debt settlement companies. Some companies have little to no cost for you, but you’ll make payments to them rather than to your creditors. You’ll usually close all outstanding accounts — like credit cards — until your debt is paid off.

Before starting, ensure that you’re working with an accredited agency, like American Consumer Credit Counseling, the National Foundation for Credit Counseling or Financial Counseling Association of America.

Balance transfers

A balance transfer is when you move your outstanding credit card debt to a new credit card that offers 0 percent APR for a set amount of time, usually between 12 and 24 months. This means you’ll be able to make low monthly payments without the extra cost of interest added to your outstanding balance every month. But once the 0 percent interest term ends, you’ll get charged interest on anything that isn’t paid in full every month.

The best balance transfer credit cards won’t charge a fee to transfer your outstanding balance. But keep in mind that not all balance transfer credit cards will transfer your full outstanding balance. This could mean that you’re on the hook for paying off your new balance and whatever didn’t transfer over.

Beware of debt settlement scams

While many companies look out for your best interest, some debt settlement companies are scams. You can avoid fraudsters by:

  • Avoiding businesses that make false promises: If a company says that it can make your debt go away and stop debt lawsuits and collections, beware. Remember, your creditor isn’t obligated to accept a settlement, and some won’t work with debt settlement companies. Getting your debt and related problems to disappear is not a guarantee.
  • Not paying fees before debt settlement: If your debt settlement company requires money before it’s done any work, that’s a red flag. Read the fine print when it asks for payment, and make sure that you know what it’s going toward.
  • Keeping up with communications: If your debt settlement company doesn’t tell you about the risks involved in debt settlement or the consequences of not making payments to your debt collectors, that’s a problem. You should know every risk before handing over your money (or pausing payments), and it’s your debt settlement company’s job to make sure that you’re aware of what’s at stake.

The bottom line

While debt settlement might sound like a great idea, it’s not always the best option for tackling your debt. Some creditors and debt collection agencies don’t work with debt settlement companies, and some don’t do settlements at all. And even if they do, it could take years before a settlement is reached. Imagine waiting to pay multiple types of debt and the damage it could do to your credit during that time.

You have other options, including debt consolidation, debt management plans, credit card balance transfers and even bankruptcy. Evaluate all your options before deciding, and don’t be afraid to change course if it’s not working out like you expected.

Learn more:

Written by
Dori Zinn
Contributing writer
Dori Zinn has been a personal finance journalist for more than a decade. Aside from her work for Bankrate, her bylines have appeared on CNET, Yahoo Finance, MSN Money, Wirecutter, Quartz, Inc. and more. She loves helping people learn about money, specializing in topics like investing, real estate, borrowing money and financial literacy.
Edited by
Associate loans editor