What is Debt Settlement? Pros and Cons

Debt relief companies, including settlement companies, can help reduce your balances and put your mind at ease. But, before working with a debt settlement service, consider the fine print and risks that may have a longstanding impact on your credit. Discover how debt settlement works and whether or not it's right for you.

What is debt settlement?

Debt settlement, a form of debt relief, is when a creditor agrees to accept less than what you owe them to settle the account.

If you’re having trouble repaying debt, your creditor (or the debt collection agency that has taken over the debt) may be willing to take a lesser amount of money to get the debt off their books.

Depending on the agreement, the settlement amount can be paid in a lump-sum payment or through an installment payment plan.

How does debt settlement work?

If you decide to hire a debt settlement company, the process should start with you receiving disclosures from the company outlining the cost and terms of the service.

• You set money aside. Typically, you’ll be instructed to put a certain amount of money into a particular savings account every month as part of the debt settlement program. This bank account will be used to pay your creditors once an agreement is reached.
• You stop making payments to your creditors. The debt settlement company may also tell you to stop making payments on your debt during the negotiations. Basically, your non-payment is used as a bargaining tool to convince the creditor to take a debt settlement, but it can take years for this agreement to happen.
• You begin making payments. If your creditor accepts a settlement offer, you will start making payments to satisfy your end of the deal. According to the American Fair Credit Council, accounts typically settle for 33% less than the total debt owed when fees are considered.

Let's look at an example using a 33% settlement amount. If the total debt on your credit card is $15,000, you could end up paying somewhere around $10,050 with a debt settlement company.

Once the debt is settled, the account balance will be removed from your credit report, and the account will state that you settled with the credit card company in question.

According to the Federal Trade Commission (FTC), debt settlement programs may require you to deposit your money into a savings account for 36 months or more until a settlement is reached.

Unfortunately, missing payments for such a long period can cause your debt to skyrocket due to late fees and interest charges. It could also impact your credit.

What are debt settlement programs?

A debt settlement program is offered by a for-profit business called a debt settlement company or debt relief company. Essentially, these businesses work with your creditors to negotiate a deal allowing you to pay off (settle) your debt for less than the total amount.

If you owe multiple creditors and a debt settlement company has negotiated a settlement with all of them, you will only need to make a single monthly payment to the company that negotiated on your behalf to fulfill the settlement terms.

Eliminating your debt is often a win-win scenario for all parties — you’re no longer on the hook for the full amount of your balance, and the debt collector also gets some money.

Best debt relief companies at-a-glance

National Debt Relief and Freedom Debt Relief are established and accredited debt relief companies. Each company offers slightly different debt relief solutions.

However, both offer free consultations and debt counselors to help you create a plan that works for you. They also work on a similar fee structure and have the same minimum debt balance requirements for using their services.

Read more in our reviews of National Debt Relief and Freedom Debt Relief.

	Freedom Debt Relief	National Debt Relief
Minimum debt	$7,500	$7,500
Program length	24-48 months	24-48 months
Fees	15-25% of total enrolled debt	15-25% of total enrolled debt
Availability	Approximately 38 states	42 states
	Visit Freedom Debt Relief	Visit National Debt Relief

Should you settle your debt or pay it in full?

Paying your total debt in full is better than settling your debt for several reasons. The main difference is how each affects your credit score.

If you work with a debt settlement company, any resolved account will be marked as "settled in full" on your credit card.

While this puts you right with your original creditors, it shows potential lenders that you paid less to your lenders than you originally agreed. This could have a negative impact on your credit score and ability to borrow in the future.

On the other hand, any debt account balances you completely pay off will be marked "paid in full" on your credit report. This signals to potential future lenders that you have a history of paying off every dollar you borrow and could help improve your credit score.

What types of debt are eligible for settlement?

You may not be able to settle every type of debt you have. It’s important to understand the difference between secured vs. unsecured debt.

Unsecured debt is the type of consumer debt eligible for debt settlement. Secured loans are already backed by property, such as your car or house.

That means the lender can repossess and sell that property to recoup its cost, so there’s no incentive for these lenders to negotiate a settlement with you.

Here are examples of debt you may be able to settle using a settlement company:

• Credit card debt
• Medical bills
• Unsecured personal loans
• Payday loans
• Private student loans

Cons of debt settlement

While a debt settlement can give you some financial breathing room, it's not always an ideal solution. Here are a few drawbacks of working with a debt relief service.

• No guarantees. There’s no guarantee a creditor will negotiate a settlement just because you sign up with a debt settlement company. You could find yourself with months (or years) worth of late fees and interest on your accounts and no settlement to show for it.
• You could face legal action. Your creditors could file a lawsuit instead of offering you a settlement on your outstanding debt, putting you in a legal bind.
• It may negatively impact your credit. Long-term non-payment can wreak havoc on your credit history, especially if you start the program with decent credit (more on that in a second).
• It's not free. Working with a debt settlement company also isn’t free. Companies typically charge fees equal to a percentage of the settled debt. These fees come due once a settlement agreement is reached.

• You may still owe taxes on your debt. After the settlement, you’re not entirely in the clear because Uncle Sam may want a cut of what you didn’t pay. That forgiven debt balance may be considered taxable income, resulting in a debt settlement tax bill.

Pros of debt settlement

We’ve talked a lot about the disadvantages, but what are the advantages of taking a settlement?

• Avoid bankruptcy. A settlement may help you avoid filing for bankruptcy. Also, settling debt means you could get creditors off your back and stop all those overwhelming collection calls. Without debt causing financial stress, you could have more wiggle room to work toward other goals, such as growing your savings account.
• You can make arrangements yourself. You may be able to negotiate with your lenders and maybe even arrange your debt settlement plan without defaulting on the debt. This strategy will save you fees to a settlement company and help preserve your credit history because you won’t have missed any payments.
• Better for your credit score than defaulting. According to Experian, having a debt listed as settled still isn’t great for your credit score, but it may have less of an impact than not paying at all. A debt settlement could do even less damage to your credit if you can convince the creditor to list your account as paid in full instead of settled.

How does debt settlement affect your credit?

In addition to the debt settlement pros and cons listed above, a settled status on your credit history is a negative record that can cause your credit score to take a hit.

What's more, the settled account can take seven years to be removed from your credit history.

Credit utilization

On the bright side, getting rid of high credit card account balances can reduce your credit utilization ratio, which could help your score. Your credit utilization ratio accounts for 30% of your FICO Scorecalculation.

With that said, a lower credit utilization may or may not undo the damage done by missing payments ahead of a settlement. That’s because payment history accounts for 35% of your FICO score calculation.

Missed payments

The degree to which missed payments impact your score depends on your finances and history. According to data from the leading credit bureaus, missing payments do more harm to your score the higher your credit score.

For instance, someone with good credit (a FICO Score of 710) could lose as many as 180 points if a payment is 90 days late. Meanwhile, someone with a FICO Score of 607 might lose 47 points when a payment is 90 days late.

If your credit is already less-than-stellar, the benefits of settling debt could be worth the credit hit because you can work on rebuilding with a clean slate.

How to choose a debt settlement company

If you decide to go the settlement route, here’s how to pick the best debt settlement company for you:

• Compare fees. Shop around with multiple companies to compare prices and terms. Opting for a company that doesn't charge upfront fees is typically a good idea.
• Look at the company’s track record. Check the Better Business Bureau to review company ratings and search the Consumer Financial Protection Bureau database for complaints. The FTC also recommends checking with your state attorney general’s office to see whether complaints have been filed against the company.
• Read customer reviews. See what people are saying about the company and its customer service.
• Ask questions. Check each company's website or call and ask about their debt settlement process, including how long the debt negotiation process typically takes.

National Debt Relief vs. Freedom Debt Relief

Minimum debt	$7,500	$7,500
Types of debt	Credit card debt Payday loans Store credit cards Unsecured debt (including medical debt and personal loans) Private student loans	Credit card debt Payday loans Store credit cards Unsecured debt (including medical bills and personal loans) Private student loans
Program length	24-48 months	24-48 months
Fees	15%-25% of the amount of your total enrolled debt	15%-25% of the amount of your total enrolled debt
Availability	42 states	Approximately 38 states
Accreditation	AFCC, IAPDA	AFCC, IAPDA
Best for...	Clients looking for top-notch customer service	Clients with hefty debt balances looking for affordable debt relief
	Visit National Debt Relief	Visit Freedom Debt Relief

How to avoid debt settlement scams

Unfortunately, the debt relief industry is known for scams. Companies may try to take advantage of people’s financial hopelessness and fear, so don’t make a decision in desperation if you’re considering debt settlement.

The scams often involve promises that settlement companies simply can't guarantee.

A settlement company can’t guarantee that your creditor will be open to negotiating or guarantee to erase a specific percentage of your balance. Nor can a company state that it can make your debt disappear or stop litigation if you don’t pay your debt.

The FTC also warns against doing business with settlement companies that charge you money before attempting to settle your debt.

The debt settlement company should disclose the fees, how long the process will take, how much you need to save for the settlement, and the risks involved if you don’t make debt payments.

If a debt settlement company sounds too good to be true, it's a sign that you could be getting scammed. If you’re the victim of a debt settlement scam, you can file a complaint with your state attorney general’s office.

Alternatives to debt settlement

Signing up for a debt settlement program with a company isn’t something you should do without considering other options first. Here are some alternatives.

Negotiate yourself

Instead of paying a debt settlement company a fee for the service, you can try to negotiate with creditors on your own.

If you’re going through financial hardship because of the pandemic, creditors may be willing to establish a payment arrangement so you don’t default.

Creditors may prefer to speak with you and, in some cases, refuse to speak with settlement companies. Learning how to settle credit card debt yourself can often be as easy as picking up the phone.

Use a debt consolidation loan

If you’re juggling many payments to different creditors, you may be able to consolidate your debt with a debt consolidation loan. This will combine all your debt under one new loan for more manageable repayment.

Debt consolidation loans are often installment loans with a fixed interest rate and repayment term.

To help you decide which option is right for you, read our debt settlement vs. debt consolidation guide.

Consider a balance transfer credit card

Some credit cards offer new cardholders a 0% APR balance transfer special where you pay no interest on transferred debt during an introductory term. If approved, you could have over a year of interest-free time to repay your debt.

For instance, the Citi Double Cash^® Card offers a 0% intro APR on balance transfers for 18 months (then 19.24% - 29.24% (Variable) APR).

Check out our list of the best balance transfer cards if you're interested in comparing cards.

Try credit counseling

A nonprofit credit counseling agency may help you with a debt management plan so you can tackle your outstanding balance.

A credit counselor provides guidance and support for consumer credit, including reviewing your finances and negotiating with creditors to secure lower interest rates and fees. You make one payment to the counseling agency, which disburses it to your creditors.

Enrolling in this kind of debt repayment plan won’t hurt your credit score, but credit counseling companies typically charge an upfront fee and monthly fees.

According to the National Foundation for Credit Counseling, the cost should be around $50 or less upfront and $25 per month. This could be much less than paying a debt settlement company and the IRS in taxes owed on the settled debt.

Speak with an attorney about bankruptcy

If you’re at a point where you don’t have enough cash to spare to save for a settlement and your debt payments are not manageable, you might consider the bankruptcy pros and cons.

A bankruptcy attorney can discuss options with you, including whether you qualify for Chapter 7 bankruptcy vs. Chapter 13 bankruptcy.

FAQs about debt settlement

Bottom line

Working with a debt settlement company could be an option to consider if you’ve exhausted other repayment solutions.

Suppose you’re barely staying above water financially, and you can’t qualify for a balance transfer credit card. Or maybe you’re looking at a debt consolidation loan vs. bankruptcy. In these scenarios, debt settlement services may also be worth exploring.

Lastly, be sure you understand the risks of hiring a debt settlement company before you do so. If the settlement company can’t reach an agreement with your creditors, you could end up with a much higher unpaid debt balance and in court for the amount you owe.

Debt settlement can be the best option depending on your financial situation, but thoroughly investigate all your options before making a significant decision about your personal finances.