What Is a Debt Settlement?

If you owe money and your debt payments have become overwhelming, you can negotiate a settlement with your creditors and settle for less than you owe.

Written by Erin Gobler / May 25, 2022

Quick Bites

  • Do you owe a lot of money and are unsure of your ability to pay it back? You may be able to find relief with a debt settlement, in which you negotiate with your creditors to pay back less than you owe.
  • A debt settlement company can help you in your negotiations.
  • Debt settlement can be used for unsecured debts such as credit cards, personal loans and medical debt, but usually not for secured or government debt.
  • Be aware that debt settlement comes with several key risks, including damage to your credit score, increased costs and the chance that it won’t work at all.
  • If you’re feeling overwhelmed by your debt, there may be other better options, including credit counseling and debt consolidation.

If you’ve ever been or are currently swimming in a lot of debt, you know just how overwhelming it can feel when trying to pay it off.

We’re a debt-happy society. According to the Federal Reserve, about 77% of American families had some type of debt in 2019.[1] Unfortunately, that debt can reach unmanageable levels for some people.

There are many debt relief resources available, including debt settlement, a popular option that can help get you off the hook for some of the money you owe. We’ll dig deeper into debt settlement and whether it can make sense for you.

Inside this article

  1. What is debt settlement?
  2. How does debt settlement work?
  3. When to consider debt settlement
  4. The cost of debt settlement
  5. Risks of debt settlement
  6. Debt settlement alternatives
  7. Is it right for you?

What is debt settlement?

Debt settlement is a form of debt relief where you settle your debt for less than you currently owe. The lender gets the benefit of receiving at least a portion of what they’re owed when they might otherwise get nothing. The borrower gets the benefit of resolving their debt for a lower amount.

“Debt settlement aims to help you save 40% to 60% on your unsecured debts without filing bankruptcy,” says Lyle Solomon, a financial attorney with Oak View Law Group who helps consumers get out of debt. “Other goals include avoiding debt collection calls and getting rid of emotional stress.”

Consumers can negotiate with lenders to settle their debt themselves, however, most people work with a third-party settlement company that charges a fee for its services.

How does debt settlement work?

There are a few different methods that can be used for debt settlement. As we mentioned, many people hire a debt settlement company to handle the negotiations on their behalf.

Once you have an initial consultation with a debt settlement company and hire them to settle your debt, you’ll start making payments to that same company. Those funds usually go into an FDIC-insured (backed by the government) account and are eventually used to pay off your reduced debt.

Debt settlement companies will advise their clients to stop paying their debt during these negotiations.

“Creditors are more willing to settle a debt if they believe they may get more money for less trouble than if they demand the whole amount,” Solomon says.

Debt settlement is usually considered by creditors only for debts that are more than 90 days past due. If you are four to six months behind on your payments, the creditor is likely to offer you a settlement since beyond that point, creditors usually give up trying to collect any debt, Solomon says.

Once a creditor agrees to the settlement, you’ll pay the agreed-upon amount, which is usually 40% to 60% of the amount you currently owe. The debt settlement agreement may allow you to make reduced monthly payments, but could require one lump sum payment for the full agreed-upon amount.

When to consider debt settlement

Debt settlement might be right for you if you feel overwhelmed by your debt and don’t feel you’ll be able to pay it off without the help of debt relief.

However, not all debts are eligible for debt settlement.

For a debt to be eligible, it must be an unsecured debt, meaning there’s no collateral (something that you’ve guaranteed to back that loan and that can be forfeited) attached to the loan. As a result, debt settlement won’t help you with your mortgage or auto loan. Debt settlement also can’t usually be used for federal student loans or for any debt you owe the government, like back taxes.

Eligible debt includes credit cards, personal loans and medical bills. Other examples could include private student loans, utility bills and auto repossession balances.

Debt settlement is most successful with debts that are already delinquent, since the creditor is uncertain whether they’ll be paid back at all.

The cost of debt settlement

The cost of debt settlement depends on whether you hire a company to manage it on your behalf. If you negotiate your own debt settlement, then it doesn’t necessarily have to cost you anything. However, you may also be less successful than a company that specializes in these types of negotiations.

The downside to hiring a debt relief company is, of course, the cost. The good news is you won’t pay a dime until the company has actually settled your debt. But once that happens, the fee is likely to be around 20% to 25% of the debt amount. For example, if you have $10,000 of debt, the fee could be as high as $2,500.

If you’re considering debt settlement, it’s important to ask yourself how much you’ll really save. According to Solomon, debt can often be settled for 40% to 60% of the original amount. But if the settled amount ends up being any higher and you have to pay 25% to the debt settlement company, you’ve harmed your credit without seeing any real financial savings.

Risks of debt settlement

There are some serious risks and downsides to debt settlement. Let’s talk about a few reasons you may want to second-guess whether it’s right for you.

Debt settlement will hurt your credit

Creditors may only agree to debt settlement with someone who isn’t paying their debt, and stopping payments on your debt will cause serious damage to your credit score.

Missed payments and delinquent or defaulted debts remain on your credit report for seven years.[2] And, once the debt is settled, that settlement will also appear on your credit report and harm your credit score.

Debt settlement can knock hundreds of points off your credit score and may prevent you from borrowing money or even renting an apartment for several years. It’s important to consider this before agreeing to debt settlement.

Debt settlement isn’t always successful

There’s always the chance that your debt is unsuccessful.

Companies aren’t obligated to settle and creditors could refuse to negotiate and even seek legal action to recover what they’re owed. And all of the missed payments could add up to you owing even more in the long run, Solomon says.

Debt settlement can take years

Don’t expect a debt settlement to be wrapped up in a few months. On the contrary, it can take several years for a debt relief company to settle your debt. During this time, you’ll continue racking up late fees and negative marks on your credit report. You also likely won’t have access to credit, or to anything that requires a good credit score.

Debt settlement can result in taxable income

The Internal Revenue Service considers forgiven debt to be taxable income.[3] The amount you’ll actually owe depends on your forgiven debt amount and your tax bracket.

Tip: Find your tax bracket with the Internal Revenue Service.

For example, if you have $5,000 of debt forgiven and are in the 10% tax bracket, you could end up owing an additional $500 in income taxes for that year. Unfortunately, most people aren’t expecting this when they enter debt settlement and may not have the funds to pay on time.

Debt settlement alternatives

Debt settlement is not the only alternative if you’re in debt, and may not be the best option.

“Although debt settlement damages your credit in the near term, it is frequently the most effective approach to get your finances back on track,” Solomon says. “There are, however, other viable options for paying down debt.”

Let’s talk about a few alternatives to consider if you’re struggling to pay off debt.

Credit counseling

Credit counseling is a great first step for anyone struggling to pay down their debt. Credit counselors offer tips on managing your money, getting on a budget and paying off your debt.

It’s not necessarily an immediate solution, but it’s a more permanent and holistic solution. You will then be equipped with tools and knowledge that will help you support your financial health for the rest of your life.

Debt consolidation

Debt consolidation involves consolidating multiple unsecured debts into a single personal loan with one monthly payment, a way to simplify your life. Additionally, debt consolidation may help you get a lower interest rate, especially if you’re consolidating credit card debt.

Debt management

A debt management plan is another type of debt relief, but rather than settling your debt for a lower amount, you work with your creditors to reduce your interest rate or monthly payments. Debt management can make your monthly payments more manageable, which makes it easier to tackle your debt. When you agree to a debt management plan, creditors may also waive or reduce any late fees or penalties you’ve accrued.

One of the major benefits of debt management over debt settlement is the effect it has on your credit.

As we’ve discussed, debt settlement harms your credit because it requires that you stop making your monthly payments. With debt management, you’re continuing to make monthly payments and are actually making progress on your debt, meaning your credit score will slowly improve.


Filing for bankruptcy should be your last resort for eliminating debt. It’s a legal process that helps you to get a fresh start by eliminating your debt.

But bankruptcy comes with some serious downsides. First, you must work with a court trustee to liquidate your assets to cover as much of your debt as possible. The remaining debts will be discharged, but at a serious long-term cost.

Bankruptcies remain on your credit report for 10 years instead of seven.[4] During that time, you’ll seriously hinder your ability to access new credit and even qualify for some jobs.

Is debt settlement right for you?

If you’re struggling to pay off your debt, then debt settlement might be right for you. In general, debt settlement can be a good idea if you meet the following criteria:

  • You have unsecured debt such as credit cards, personal loans, medical bills, etc. Remember that debt settlement can only be used for unsecured debt and can’t be used for government debt like student loans and taxes.

  • You are already delinquent on your debts. Debt settlement is most successful for someone who is at least four to six months past due on their debts. If you’ve already missed several payments, debt settlement may be the best option.

  • You have the ability to make a lump sum payment. In many cases, debt settlement requires you to make a lump sum payment for the reduced debt amount.

  • You can’t pay off your debt otherwise. Debt settlement helps to settle your debt for less than you owe, which sounds like a great deal. But it comes at a cost, both in the form of the fees you’ll pay the debt settlement company and in the hit to your credit score.

As you can see, debt settlement comes with serious consequences. Whether it’s right for you will depend greatly on your individual situation. Proceed with caution.

Article Sources
  1. “Changes in U.S. Family Finances from 2016 to 2019: Evidence from the survey of Consumer Finances,” Federal Reserve Bulletin, ​​https://www.federalreserve.gov/publications/files/scf20.pdf.
  2. “How Long Do Late Payments Stay on Credit Reports?” Experian, https://www.experian.com/blogs/ask-experian/how-long-do-late-payments-stay-on-credit-reports/.
  3. “Topic No. 431 Canceled Debt — Is It Taxable or Not?” IRS, https://www.irs.gov/taxtopics/tc431.
  4. “How Long Does Bankruptcy Stay On Your Credit Report,” TransUnion, https://www.transunion.com/blog/credit-advice/how-long-does-bankruptcy-stay-on-credit-report.

About the Author

Erin Gobler

Erin Gobler

Erin is a personal finance expert and journalist who has been writing online for nearly a decade. Erin’s work has appeared in major financial publications, including Fox Business, Time, Credit Karma, and more.

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