If you’re overwhelmed by debt and struggling to keep up with payments, you might be wondering: is debt settlement a good idea? The answer depends on your personal situation, the kind of debt you owe, and what alternatives are available. Debt settlement can be helpful in some cases, but it also comes with serious risks that need to be weighed carefully.
This guide will walk you through what debt settlement is, how it works, the pros and cons, and how it compares to other options like credit counseling, debt management, and debt consolidation. We’ll also provide important information on how to protect yourself from scams and make the best choice for your financial situation.
Debt settlement is a process where you or a third-party company negotiate with your creditors to reduce the total amount you owe. If successful, you might pay less than the full balance to settle the debt, often in a single lump sum. The goal is to reach an agreement where the creditor agrees to accept a partial payment as “payment in full.”
This option is usually offered to people who are behind on their credit card payments or other unsecured debts, such as personal loans. Creditors may agree to settle a debt when they believe they won’t get the full amount otherwise.
While debt settlement has some serious downsides, it can also offer relief when used appropriately. Here are some potential benefits:
The most obvious benefit is saving money. If you can negotiate a lump sum that’s significantly less than your full balance, you could become debt-free sooner and for less.
For example, a $15,000 credit card debt could be settled for $7,500, depending on your creditor’s willingness to negotiate.
Debt settlement is often seen as a last resort before filing for bankruptcy. While bankruptcy wipes out most debts, it comes with even greater damage to your credit score and remains on your credit report for up to 10 years. If you qualify for settlement and can pay the negotiated amount, you may be able to avoid bankruptcy and its long-term effects.
If you have multiple unsecured debts, settling some of them can reduce the number of accounts you’re juggling. This simplifies your financial situation and may reduce your stress.
Once a debt is settled, that account is closed and collection efforts should stop. This can be a huge relief if you’re being harassed by a debt collector.
Despite the benefits, debt settlement may not be a good fit for everyone. Here are the downsides to consider.
As mentioned earlier, your credit score will take a hit, especially if you’ve stopped making payments. Accounts marked as “settled” don’t look good to future lenders. This can make it harder to qualify for new credit, loans, or even some jobs or rentals.
The IRS considers forgiven debt to be taxable income. So, if your creditor agrees to cancel $5,000 of your debt, you may have to report that amount on your federal income taxes. You might receive a 1099-C form and owe additional taxes unless you qualify for an exclusion or exception.
Some creditors simply don’t negotiate or may refuse to accept anything less than full payment. Others may send your debt to a debt collection lawsuit, especially if they think you have the ability to pay.
There are bad actors in the industry. Some companies promise fast results or guaranteed savings, which is a red flag. Never pay upfront fees for debt settlement services, and always read the fine print.
If you’re not careful, a scam could leave you deeper in debt with no results. Use resources like the Consumer Financial Protection Bureau (CFPB) to check a company’s background before committing.
Debt settlement isn’t the only way to deal with unaffordable debt. Other options may provide similar or better results with less risk.
A certified credit counselor can help you review your budget, discuss your financial situation, and explore your best options. They work for nonprofit credit counseling agencies and are often available at no cost.
To learn more, check out What is Debt Counseling and How Can it Help You?
If you’re overwhelmed but want to repay your debts in full, a debt management plan (DMP) might be a better fit. These plans allow you to make one monthly payment to a credit counseling agency, which then pays your creditors.
DMPs often come with reduced interest rates, waived late fees, and no collection calls. This helps you pay off your balances in 3 to 5 years while preserving your credit score.
Read more: When should you consider a debt management plan?
If your credit score is still strong, a debt consolidation loan may help you convert all of your debts into one new loan at a lower interest rate. This keeps your accounts current and avoids credit damage, but requires you to qualify with a lender. It also frees up your existing credit card balances, which can often lead to more debt in the long run.
When it comes to repaying debt, we generally advise against any solution that involves getting a new loan. Compare this to a debt settlement approach carefully before deciding.
Some consumers choose to contact creditors directly to negotiate settlements. This is called DIY debt settlement. It avoids the fees charged by most debt settlement companies, but it requires time, patience, and a good understanding of the process.
If you’re confident in your negotiation skills and know your rights, this can be a cost-effective option.
To start the process, you usually need to stop making payments on your debts, which allows them to become delinquent. At that point, creditors might be more willing to negotiate. You or a debt settlement company will then offer a reduced payment to settle the account.
Here’s a simplified outline of the typical process:
One of the biggest concerns people have is how debt settlement affects their credit score. Unfortunately, this option usually has a negative impact. When you stop paying your debts to encourage settlement, your credit report will show missed payments, which lowers your credit score.
Even after a debt is settled, the account will not show as “paid in full.” Instead, it will be marked as “settled for less than the full balance,” which tells future lenders that you didn’t repay the full amount you owed.
Depending on your current credit score, this could drop your score by 100 points or more. If you’re already behind on payments, your score may already be damaged, in which case the added impact might not be as severe. Still, it’s important to know that the credit score damage from debt settlement can last for several years.
For more on how unpaid debts affect your credit over time, read our article “Pros and Cons of Paying off Old Delinquent Credit Card Debt”.
Debt settlement typically applies to unsecured debt. This includes:
Secured debts, like mortgages or car loans, are not usually eligible because the lender can take the collateral if you stop paying. Federal student loans also do not qualify for settlement through private companies, although government programs may offer other relief options.
Debt settlement can be done on your own, but many people turn to third-party companies for help. These debt settlement companies negotiate with creditors on your behalf. However, not all companies are trustworthy.
Before you choose to work with a company, make sure they are licensed and have no record of debt settlement scams. Keep in mind that most debt settlement companies charge fees, usually a percentage of the amount saved. This fee is only charged after a successful settlement, not upfront, according to rules from the Federal Trade Commission.
Want to compare this option to others? Learn more in our guide on “Debt Management vs Debt Settlement: What’s the Difference?”
Now that you know the pros and cons, how do you decide if debt settlement is the right path? Here are some scenarios where it may be worth considering:
If you’ve missed multiple payments and are facing collection efforts, your creditor may be more open to negotiating. This is especially true for large amounts of credit card debt, which is one of the most commonly settled types of debt.
People without major assets, such as a home or car, may be better candidates for debt settlement. If a creditor sues you, they may not have much to collect beyond your income, which makes settling more appealing to them.
If you have a lump sum of money saved or a consistent income that allows you to make a single large payment, your chances of reaching a successful settlement are much better.
Some people do not qualify for bankruptcy or want to avoid it because of the long-term consequences. In that case, settling your debts might offer a workable middle ground.
If you are considering bankruptcy, call us for bankruptcy counseling and education.
There are also times when debt settlement may not be your best option. Consider avoiding it if:
Understanding how debt settlement stacks up against other options is important. Let’s take a closer look at the main alternatives.
A debt management plan helps you pay off your full balance over time with reduced interest and waived fees. It is administered through nonprofit credit counseling agencies. This option helps protect your credit score and avoid lawsuits.
Debt settlement, in contrast, involves paying less than you owe, usually after falling behind. It hurts your credit and may lead to lawsuits or tax consequences. For a full breakdown, see our article on Debt Management vs Debt Settlement: What’s the Difference?
Working with a credit counselor can help you understand all your options, including settlement, consolidation, and budgeting. These services are typically free or low cost and offer an unbiased look at your financial situation.
For more, visit What is Debt Counseling and How Can it Help You?
Debt consolidation uses a new loan to pay off old debts. You then make one monthly payment, usually at a lower interest rate. This can simplify your bills and preserve your credit standing, but requires good credit to qualify.
Debt settlement is more likely used by those who have already fallen behind and can’t qualify for new credit. While it may reduce the total amount owed, it comes with more risk and long-term credit impact.
If you decide to pursue debt settlement, it’s helpful to know what to expect step-by-step.
Some companies may require you to deposit funds into an escrow account over time until there’s enough to make a lump-sum settlement.
Make sure you get all agreements in writing before making any payments. Always check the company’s reputation and avoid those that charge fees upfront.
Once your debts are settled, the next step is rebuilding your finances. Creating a strong budget is key to staying on track. Consider using free tools like our Budgeting 101 Course or the Power of Paycheck Planning course to build better money habits and avoid falling back into debt.
If you’re considering hiring a company to help with debt settlement, be cautious. While some companies operate within legal and ethical guidelines, others may take advantage of consumers.
Avoid any company that:
You can report suspicious companies or check their history through the Consumer Financial Protection Bureau or your state attorney general’s office.
If you decide to work with a third-party service, look for companies that:
Once your debt is settled, you’re not entirely in the clear. Here’s what to expect afterward:
After settling your debts, it’s time to focus on rebuilding your credit and financial stability.
Start by reviewing your credit reports from all three major credit bureaus. Make sure the settled accounts are reported correctly. You can get free reports at AnnualCreditReport.com.
Your payment history is the most important factor in your credit score. Set reminders or use autopay to avoid future late payments.
Try not to take on new debt immediately, but if you do, use it wisely. Consider a secured credit card or credit builder loan, which are tools designed to help rebuild credit.
Debt settlement may solve part of your problem, but it doesn’t address the behaviors or financial habits that led to debt in the first place. That’s why it’s important to combine settlement with financial education and ongoing budgeting support.
Explore our free financial education resources, including the Power of Paycheck Planning program, to develop long-term habits that help you stay out of debt.
Debt settlement can be an option for people who are behind on payments, have few assets, and are trying to avoid bankruptcy. It can offer relief, but the trade-offs include serious credit score damage, possible tax consequences, and the risk of scams.
It’s not a one-size-fits-all solution. For many people, safer alternatives like credit counseling, debt management, or debt consolidation offer more sustainable ways to regain control.
Before you commit to any one option, consider speaking with a certified credit counselor. They can help you weigh all your choices and create a plan that’s right for you.
