What Is Debt Settlement?

Financial difficulties may build slowly or arrive all at once. If you're unable to cover household bills and debt payments at the same time, that's a common experience, and researching solutions is a strong step forward.

Debt settlement is a way to resolve unsecured debt, such as credit card balances or medical bills, by negotiating with creditors to accept less than the full amount owed. A successful settlement could clear a balance faster and for less money than paying only the minimum each month. Here's a closer explanation of what debt settlement is, how it works, and what it typically costs.

Debt Settlement Meaning

Debt settlement is a negotiation process: you, or a debt settlement company working on your behalf, present your case to creditors and try to reach an agreement to repay less than the full balance owed. Learn more about how Freedom Debt Relief works.

The process of debt settlement

The debt settlement process begins when you realize you're unable to pay what you owe, and seek help. You might reach out to your creditors directly to offer a reduced amount, or work with a professional debt settlement company to handle negotiations. Creditors may be more willing to negotiate if they understand you're facing a financial hardship that makes it difficult to repay the full amount owed, since recovering something is generally preferable to recovering nothing.

Common risks of debt settlement include a negative impact on your credit score and the possibility of owing taxes on forgiven debt if you're not insolvent when the debt is settled.

Anyone may negotiate their own debts. The process is often time-consuming and stressful, and it typically requires several rounds of communication with each creditor.

A debt settlement company can shoulder the stress and the work of negotiation for you. A professional debt expert can review your situation and reach out to your creditors to discuss reduced payments. There's no guarantee that creditors will agree to settle, even when a debt settlement company is involved, but it may be worth the attempt if you're stuck because of an extended hardship.

Eligibility for debt settlement

In most cases, those eligible for debt settlement are borrowers who show they're struggling to make debt payments. The types of debt usually eligible are unsecured debts, including:

• Credit card debt

• Department store charge card debt

• Personal loan debt

• Medical debt

• Some private student loan debt

• Buy now, pay later debts

• Parking tickets

• Deficiency balances (such as money you still owe after your car is repossessed)

Secured debts like mortgages and car loans are not eligible for debt settlement.

What about business debts? A small-business owner who used personal credit cards for business expenses could enroll that debt in a debt settlement program; a debt settlement company typically doesn't help with business debts.

Can you settle debt on your own?

You may attempt to settle your own debts and could save money by doing so, especially if you're comfortable negotiating financial matters and have only one or two accounts to coordinate. When you settle debt on your own, you take on the role of your own debt settlement consultant and negotiator. The process typically includes these steps:

• Assess your finances, including your income, what you owe, and what you're able to pay.

• Decide which debt(s) to settle first, such as the smallest balance or the highest rate.

• Contact your creditors, using a written script to stay on track.

• Negotiate a reduced payoff, starting lower than your maximum, and get it in writing.

• Make your payment as agreed, by a secured method, before the deadline, and keep records.

• Confirm the account is zeroed out, closed, and reported to the credit bureaus as settled.

Many creditors require an account to be significantly past due before they'll negotiate. 

If you run into difficulty negotiating on your own, professional debt settlement is an option that may be less stressful and could produce a better outcome.

What Debt Settlement Costs

Debt settlement companies typically charge 15% to 25% of the total enrolled debt, and by law, that fee is due only after a debt is settled, not upfront. For example, on $10,000 of enrolled debt at a 25% fee, the company's fee would be $2,500, on top of the negotiated amount owed to the creditor. Ask any company for its exact fee structure in writing before you enroll, and be wary of any company that demands payment before services are rendered.

Forgiven debt can also carry a tax cost, since the IRS treats canceled debt as income unless an exception applies. If you're insolvent at settlement, meaning the value of your debts is bigger than the value of the things you own, you may be exempt from federal tax on the forgiven amount. A tax professional is best positioned to evaluate your situation.

Pros and Cons of Debt Settlement

If you're considering debt settlement, you should be aware of both the pros and cons.

Advantages of debt settlement

May reduce what you owe: Debt settlement works to lower the amount you owe, which could provide relief and help you avoid falling further behind on payments.

Could streamline monthly payments: One main advantage to debt settlement is the ability to streamline multiple debt payments into a single monthly deposit. Instead of paying your creditors individually, a debt settlement company usually sets up a dedicated account where you make a single affordable monthly deposit as you save up funds for making offers.

May cost less than alternatives: Fees typically apply. The goal is to still end up paying less in total than you would have owed without negotiating.

May be a viable alternative to bankruptcy: Debt settlement programs may offer more favorable repayment terms than bankruptcy, and settlement is private, while bankruptcy is a matter of public record.

Disadvantages and risks of debt settlement

Impact on your credit score: The debt settlement process typically involves setting aside money for settlement offers instead of paying creditors directly. A missed payment is harmful to your credit score, and missed payments generally stay on a credit report for up to seven years. The impact tends to lessen over time as you rebuild your payment history.

Creditor or collection agency calls: If your debt goes into collections, debt collectors may try to contact you.

Potential legal action: Some creditors may threaten or take legal action to collect a debt. It's important to understand your legal rights during the debt negotiation process.

If you work with Freedom Debt Relief, if a creditor takes legal action against you for an enrolled debt, we may engage a Legal Partner Network attorney who will attempt to negotiate a settlement. This service is free for qualifying clients who have made their monthly deposits on time. The offer does not apply to legal action taken before you enrolled, or to legal action taken on debts that are not enrolled.

Possible taxes owed: Forgiven debt is generally treated as taxable income unless you're insolvent at the time of settlement.

Financial relief is possible when you settle for less than you owe, and understanding the risks matters just as much. A conversation with a reputable debt settlement company may help clarify whether the potential benefits outweigh the risks for your situation.

How to Choose a Reputable Debt Settlement Company

Research how debt settlement companies operate before you choose one. Look for a reputable company with a proven track record, reasonable fees, and dedicated support to guide you through the settlement process.

Red flags to watch for

Read every document carefully before you sign, and verify a company's state licensing before you commit. Here are red flags to watch for when evaluating a debt settlement company:

Unrealistic language: Debt doesn't disappear "like magic," and no firm has the power to promise it will settle debt for "pennies on the dollar." Creditors aren't required to negotiate at all, so a provider that promises to settle your accounts is breaking the law. Avoid companies that reference a "secret" government program.

No customer reviews: Most reputable debt resolution companies will have an online presence. If you're unable to find any reviews for the company on trusted websites like the Better Business Bureau, or speak to anyone who has worked with them, you may want to steer clear.

No clear negotiation process: A good company should be able to explain clearly and exactly how it'll help you negotiate debts and the ways it'll keep you informed throughout the process.

Unclear fees: Avoid any company that charges upfront settlement fees or doesn't detail its fees before you sign a contract. Federal regulations prohibit charging debt settlement fees before a creditor agreement is reached and a payment is made toward the settlement.

Untrained counselors: Confirm your debt counselor is experienced and trained in negotiating with creditors. Companies that belong to the Association for Consumer Debt Relief (ACDR) agree to a strict code of conduct tied to Federal Trade Commission regulations; a company that isn't an ACDR member may warrant extra scrutiny.

Key questions to ask before you sign up

Before working with a debt settlement company, speak to each one to assess whether it provides the integrity, experience, savings, and customer service you deserve. To choose a company that could best help resolve your credit card and other debt, ask these key questions:

• How much will the program cost each month?

• What are the program's negotiation fees?

• How many creditors have you settled debts with?

• How will you keep me informed during the debt negotiation process?

• Where can I read client reviews from real clients?

Find more information in the Freedom Debt Relief FAQ. Trust your instincts: if something feels off about a company, it's generally not the best fit for you.

Common Myths and Misconceptions About Debt Settlement

Don't fall for these false claims about settling your debts.

Myth: Debt settlement is an easy way out

Debt settlement isn't quick or effortless, and it may take longer than expected. It requires a solid plan and a genuine commitment to finish what you start.

Myth: All debts can be settled

Secured debts like auto loans and mortgages, and government debts like back taxes, generally aren't eligible for settlement. Weigh the time and effort involved before you settle unsecured debt.

Myth: Debt settlement stops a creditor from suing you

Debt settlement won't stop a lawsuit if a creditor decides to sue, even if they've attempted to negotiate with you so far. Only bankruptcy can halt lawsuits and other actions, like a bank account levy.

Steps to Take After a Debt Settlement

A completed debt settlement may help you regain strong financial footing. A resolved balance, even a partial one, could put you in a better position to manage your finances going forward.

Rebuild your credit

After a debt settlement is complete, your credit score may be lower than you'd like. Here are some ways to work on improving it:

• Check your credit reports and dispute any errors you find.

• Make consistent on-time payments on all your debts.

• Avoid applying for loans or credit cards until you really need to.

• Avoid carrying credit card balances.

Avoid future debt challenges

A plan to avoid taking on more debt than necessary could help you stay on solid financial ground. One strategy is building an emergency fund, ideally in a separate bank account, for unexpected expenses: a goal that may feel more manageable now that you have experience setting money aside in a dedicated debt settlement account. It's fine to start small.

You might also seek additional personal finance advice, such as learning how to budget with the income you've got so that you're better able to manage expenses.

Is Debt Settlement Right for You?

Not every debt relief option is right for everyone.

Who should consider debt settlement?

Debt settlement is not the best debt solution for everyone. It's for people who aren't able to fully repay their debts.

Those who aren't in deep financial trouble typically have less drastic options, like DIY debt payoff strategies or debt consolidation. Consumers with high credit card debt and few assets, and people facing lawsuits, may find bankruptcy the best choice: Chapter 7 may discharge unsecured debts for qualifying filers and put a temporary hold on filed debt lawsuits.

Debt settlement requires a strong commitment to resolving debt, a willingness to budget and live within your means, and readiness to accept an effect on your credit score. For those who don't qualify for Chapter 7, or who own assets they might lose in a bankruptcy, settling debt independently or with a professional debt settlement company could be a smart financial move. If you're on the fence, a bankruptcy attorney or a debt consultant is available to help you compare options.

Alternatives to Consider

Some options to consider instead of debt settlement include:

DIY debt payoff: There's no fast or effortless way to become debt-free. A steady, consistent approach might be right for you if you're able to afford it. Try a debt snowball or debt avalanche.

Debt consolidation: If you qualify, a debt consolidation loan could help lower your monthly payments. Debt consolidation replaces multiple payments with one, potentially at a lower interest rate.

Debt management plan (DMP): Nonprofit credit counseling agencies manage these plans, which may lower your interest rate and payment. A DMP doesn't include debt forgiveness, but it may come with budgeting help.

Not every option is workable for every consumer. Not everyone qualifies for debt consolidation loans, for instance, because they generally require fairly good credit scores and sufficient income. And credit card debt relief options generally don't work for people with secured accounts like auto loans. The right option for you depends on your income, types and amounts of debt, and goals.