How to Avoid 8 Common Debt Settlement Pitfalls

Carrying more debt than you can manage isn't easy, and you’re not alone in feeling that way. Debt settlement is one option that could help you regain control over your finances. Like any strategy, it comes with costs and takes patience, but understanding the pros and cons could help you decide if it’s the right path for your financial journey.

If you’re considering debt settlement, a debt relief strategy that could help you get your finances back on the right track, we’ll walk you through the ins and outs. Knowing about the fees and potential problems could help you decide whether debt relief makes sense for you. 

Here are eight common debt settlement pitfalls to be aware of, and how to avoid them.

What Is Debt Settlement?

Debt settlement is a debt relief strategy where you negotiate with your creditors to get them to accept a smaller amount, but consider it full payment. It's up to each creditor to decide whether to agree to this, but many will, especially if they're concerned they might end up with nothing.

It's possible to negotiate with creditors entirely on your own by saving up money and then contacting your creditors to make an offer. Many people prefer working with a professional debt relief company. That way, experts do the negotiating on your behalf. All you have to do is put money into a designated account and approve settlement offers as they come in. 

Debt settlement companies can’t legally collect any payment until they come to an agreement with your creditor, you approve it, and at least one payment has been made. Then, they may take their debt settlement fee. 

Debt settlement typically takes between two and four years to complete, depending on how much enrolled debt you have. So it's important to understand exactly what you're getting into and the potential challenges you may encounter along the way before you begin.

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Debt Settlement Pitfall #1: Thinking Debt Settlement Is a Big Magic Wand

Solution: Focus on the right debt.

One of the biggest debt settlement pitfalls is thinking it can wipe out all your debt at once. This isn't always the case. 

Debt settlement works with unsecured debt like credit cards, personal loans, or medical bills. These debts aren't backed by collateral—something the creditor could take and sell if you can't make your payments. 

On the other hand, secured debts like mortgages and car loans are not a good fit for debt settlement. That's because the collateral itself—the home or the car—has value. So if you can't pay, the creditor can seize it and sell it. Collateral is a safety net for the lender. 

With unsecured debt, creditors don't have this option to get their money back. 

If your primary goal is to deal with your unsecured debts and leave only your secured debts to manage, debt settlement could still work for you.

Debt Settlement Pitfall #2: Not Considering Debt Settlement Alternatives

Solution: Consider other alternatives. You can do it.

One of the most costly debt settlement pitfalls you can encounter is diving in without exploring your other options. Just because debt settlement is a potential solution to your problems doesn't mean it's the only one—or the best one.

Before you decide on any strategy, consider all the ways you might get a handle on your debt, including:

Debt consolidation loans

You take out a debt consolidation loan—often a personal loan—and use it to pay off multiple other debts. Personal loans don't require collateral and typically have lower interest rates than credit cards. But not everyone qualifies for lower rates. For someone with poor credit, debt consolidation loans may not be a practical option because of the cost. 

If you’re able to get a debt consolidation loan, you'll have a predictable monthly payment. Don’t run up new debt on your credit cards or you could wind up worse off than you were before.

Debt management plan

Credit counselors help you set up a debt management plan (DMP) to get your debt under control. They also negotiate with your creditors for lower interest rates or to get rid of certain fees. As with debt settlement, the results will vary depending on how much the creditor is willing to bend.

You'll put money into a special account every month, and then it will be sent to your creditors. The payments are sometimes too high for some people because the plan is designed to fully repay your unsecured debts within three to five years. If you’ve been making minimum payments, you could be in for payment shock. But if you have a good income and you just need some professional guidance, you could be a good fit for a DMP.

DIY debt payoff plan

You can use the debt snowball or avalanche method to pay off debt across multiple credit cards. In either strategy, you’ll pay the minimum on all of your cards each month. Then, you put any extra you have toward the card with the lowest balance (snowball method) or the highest interest rate (avalanche method). When that card is paid off, you move onto the next card in line.

Balance transfer card

A balance transfer credit card lets you move your credit card balance to another card—ideally one with a 0% introductory rate for a certain number of months. There’s usually a one-time balance transfer fee. 

Balance transfers could make it easier to pay down what you owe since you don't have to worry about your debt swelling due to daily interest charges. But you'll have to choose a credit card issuer you don't already owe. Creditors you already work with have no incentive to offer you a 0% interest rate. Because of the relatively short time at the introductory rate, balance transfers aren’t a good debt consolidation option for many people.

Weigh the pros and cons of each option before deciding which is right for you. 

Debt settlement is a big gun for serious debt problems. Given some of the other pitfalls described below, it might make sense to start with something else first. Then, if that doesn't work for you, you can proceed to a strategy like debt settlement.

Debt Settlement Pitfall #3: Underestimating How Long Debt Settlement Takes

Solution: Get ready for the long haul.

A debt settlement program typically takes two to four years to complete. How long it takes you depends on how much you owe, how much you can afford to pay each month, and how far behind you're on your payments. 

During debt settlement, you’ll save up money to offer your creditors in an account that you own and control. It’s hard to afford this while also making your debt payments. So most people choose to stop paying their debts while they’re in a debt settlement program. (If you stop paying your debts, your credit score is likely to suffer.) 

Your creditors will probably reach out to you during this time. They might call you or send you letters alerting you to the amount you owe, hand your debt to a collection agency, or even sue you for the debt. You might also get hit with late fees.

You'll continue to set aside what you can afford each month in the account. When you've saved enough, the debt settlement company reaches out to your creditor and makes them an offer. The creditor will accept the offer, reject it, or make a counteroffer. 

Once a creditor has agreed to settle the debt, the debt settlement company passes the offer along to you. You can either accept or reject it. If you accept it, payment will be sent from your designated account to your creditor. Once the creditor receives the full agreed-upon amount, they let you off the hook for the rest. (Some settlements involve a single lump sum payment, and others involve a series of payments.) Most people enrolled in debt settlement programs reach their first settlement agreement within a few months.

Then, the cycle continues with new creditors until you've paid off or successfully settled all your enrolled debts. Though creditors can choose not to settle, many will, especially if there's been protracted negotiation or they fear you may declare bankruptcy, which could prevent them from getting any money from you in the future.

Charge-offs and collection actions during settlement

Expect creditors to take what action they can to get their money back when you begin working toward debt settlement. If you stop making payments, your creditor may charge off your account, meaning they'll close it because they don't expect you to be able to pay what you owe. The creditor writes off the outstanding debt as a loss and leaves a note on your credit report about the charge-off. 

This stays on your credit report for seven years from the original delinquency date or the date of the first missed payment, though its effect will diminish over time. 

Creditors sometimes sell this old debt to collections agencies, which then come after you for the money. They may contact you or send you notices in the mail requesting payment. In some cases, debt collectors may pursue legal action against you. However, this is expensive and time-consuming so it may not be in the collection agency's best interest either.

If you'd like to avoid legal action, be careful about requesting that the collection agency stop contacting you. They're legally required to stop if you ask. If they feel they have no other way to get in touch with you, they might view a lawsuit as the only way to get anything from you.

Debt Settlement Pitfall #4: Negative Impact on Your Credit Standing

Solution: Build financial stability first. Better credit naturally follows.

It's natural to worry about the effect debt settlement could have on your credit score. Creditors may be unwilling to negotiate with you if you're current on all of your payments, and many borrowers find it difficult to pay their creditors and also save up for a settlement offer. So you may decide to stop making payments to your creditors for a while.

Your payment history is the single-most important factor in your credit score calculation, accounting for 35% of your FICO Score—the most popular score used by lenders today. Even a single late payment could drop a credit score by tens or hundreds of points, but it depends on several factors like how late the payment was and how high your credit was to start with.

You might not be concerned if some of your accounts were already in delinquency. If your debt accounts are in collections or default, your credit score is probably already harmed. If you currently have good credit, you might be reluctant to let it go.

There's no guarantee a creditor will be willing to accept less than what it's owed. This will depend on who and how much you owe. A debt settlement company that's worked with a variety of well-known creditors may be able to give you some indication of which creditors might be more apt to settle a debt and which ones may refuse.

Even if a company does agree to your settlement offer, the debt may appear as "settled" rather than "paid as agreed" on your credit report. A settled debt is better for your credit standing than a delinquent debt, though. 

If you choose to go ahead with debt settlement, stay focused on your main goal: becoming financially secure.

If your debts make it impossible to keep up with your monthly bills or save for your long-term goals, a hit to your credit might be the lesser of two evils. Once you've gotten rid of those debts, you can refocus on improving your credit and building emergency savings. 

Negative marks like late payments usually only stay on your credit report for seven years anyway. Their effect also declines over time. So while a late payment six months ago might be really hard on your score, a six-year-old late payment won't be nearly as painful. If you can avoid debt going forward and demonstrate that you can make consistent on-time payments after you've completed your debt settlement program, you could notice your credit score begin to rise slowly but steadily.

Debt Settlement Pitfall #5: Going It Alone When You’re Stressed

Solution: Get professional guidance.

Anyone can negotiate directly with their own creditors. If you have the grit and patience, go for it. 

Creditors want to get paid, so they usually play hardball if you tell them you can’t afford to pay your debts. If you’re uncomfortable negotiating on your own or you’re overwhelmed by the process or you just don’t have the confidence in your ability to get the best outcome, help is available.

You don’t have to go it alone.

Working with a professional debt settlement company might make the process easier and more successful. Also, it relieves you of the burden of having to contact every single one of your creditors, likely multiple times, to make offers and negotiate terms. 

Debt Settlement Pitfall #6: Falling for a Debt Relief Scam

Solution: Choose professional debt settlement help carefully.

Reputable debt settlement companies are out there that can do the negotiating work for you. But there are also plenty of scammers posing as a company that can help you get out from under your debts quickly and easily. 

Before choosing a debt settlement company, research it carefully to make sure you're dealing with a reputable organization. Some things to look for are: 

• Long, established history in the business

• Successful track record

• Trained experts

• Membership in an industry association, such as the American Association for Debt Resolution

• Doesn’t charge fees unless a settlement is reached, you approve it, and at least one payment is made (doing so would violate federal laws)

• Doesn't make big promises about how much debt they can wipe out (there’s no guarantee)

• Doesn’t claim to prevent debt collection calls and lawsuits (they can’t)

• Doesn’t claim access to “government programs” to wipe out consumer debt (there’s no such thing)

If you come across a company that tries to charge upfront fees, promises to wipe out all your debts, or says it can eliminate your debts in just weeks, it's likely you're dealing with a scam. Don't give them any information. Instead, get the facts about debt settlement from a reputable company like Freedom Debt Relief.

Cost and fee structures in debt settlement

Legitimate debt settlement companies are legally prohibited from charging you an upfront debt settlement fee. The only fee you might pay when initially enrolling is a small, monthly fee for your dedicated account. This is often around $10 per month, and this money goes directly to the financial institution hosting the account. It doesn’t go to the debt settlement company.

In order for a debt settlement company to receive payment, they must do the following:

• Make an offer to your creditor that that creditor accepts.

• Get your approval of the settlement offer.

• Make at least one payment to the creditor.

Only then is the creditor permitted to take its payment. At Freedom Debt Relief, the debt settlement fee is 15% to 25% of the enrolled balance. This money comes directly out of your designated account, so you won't receive a bill.

For example, let's say you owe a creditor $10,000, but you work with a debt settlement company that negotiates a $5,000 settlement offer. You agree and your creditor is paid from your account. Then, the debt settlement company takes a 25% fee, which would be $2,500 for this debt. You'd be free of that debt for just $7,500 overall—a $2,500 savings.

Debt Settlement Pitfall #7: Underestimating the Tax Consequences of Debt Settlement

Solution: Consider your tax situation before you settle a debt.

Be prepared for the potential tax consequences of debt settlement. The federal government considers forgiven debts, including debts you eliminated through debt settlement, to be taxable income. 

For example, if you owe $10,000 to a creditor who then agrees to settle your debt for $5,000, the other $5,000 could be taxable in the year the creditor forgives the debt. If you’re in the 22% tax bracket, you’d owe $1,100 in taxes on that amount of forgiven debt.

However, you may not have to pay any tax on the forgiven debt, depending on your circumstances.

If you're insolvent—that is, the total value of what you owe is bigger than the total value of what you own before you settle any debts—the forgiven debt isn’t taxable. 

If you’re solvent, the government believes you could pay the taxes, and it adds the forgiven amount to your taxable income for the year. Even then, it might not result in a bill. If you normally get a large tax refund, the extra tax associated with the forgiven debt might just offset some of that. 

Consult with a tax professional before settling any debts to be sure you understand how the process could affect you.

Debt Settlement Pitfall #8: Feeling Hopeless and Lost

Solution: Have a debt expert describe the plan, your options, and what to expect.

Explain your situation to a debt expert. They’ll let you know your options and what will be expected of you. This should include how they will negotiate with your creditors and what fees you will have to pay.

Dealing with debt isn’t quick or easy, and your debt settlement professional should be there to support you through the entire process. They should be your cheerleader. If they’re not, find a new one. 

Lean on your debt expert and negotiators. Their job is to help people going through a rough time. They’ve helped others just like you.

Legal risks and creditor lawsuits during settlement

Your debt expert should also be there to support you through any potential legal risks that could arise. Enrolling in a debt settlement program cannot stop lenders from attempting to sue you for the outstanding balance. But it's as big a pain for them as it is for you. Suing someone costs time and money, and it's not guaranteed to go in their favor.

If a creditor tells you they're pursuing legal action against you, ]don't ignore it. If you don't show up in your own defense, the judge could rule in the creditor or collection agency's favor by default. Then, the court may give the creditor permission to garnish your bank account or seize your assets, in which case, they may be less interested in your settlement offers.

Fortunately, you don't have to go it alone. Freedom Debt Relief partners with the Legal Partner Network, a network of attorneys who specialize in debt negotiation. These attorneys can step in and attempt to negotiate a settlement offer on your behalf before the court proceedings go further.

There's no charge for this service as long as you're making your scheduled payments to your dedicated account. This benefit only applies to debts that were already enrolled in the program before the lawsuit was filed. 

Using Debt Settlement to Get Your Finances Back on Track

Are there debt settlement pitfalls to watch for? Yes. But knowing what they are can help you avoid them.

Using debt settlement successfully can be the turning point that eventually puts your financial problems behind you.