What is Debt Settlement and How Does it Work?

Having debt is all too common — 77% of all households carry some amount of debt. But even though it’s common, that doesn’t mean it’s easy to deal with. That’s why some borrowers turn to debt settlement for relief. It can potentially slim down what you owe, help you avoid bankruptcy and make debt repayment less overwhelming.

But is debt settlement always the right choice? We’ll explain what it is, how it works, the risks involved and other options. 

What Is Debt Settlement?

Debt settlement is a negotiation process that aims to reduce your total debt owed to a creditor. If you and the creditor reach an agreement, you will pay a lump sum less than the full amount originally owed. In exchange, the creditor will forgive the remainder of the debt.

Once the debt is settled, the creditor can’t hassle you for more money. However, the process can take several years, and it isn’t always possible to settle the debt.

Keep in mind that debt settlement is only an option for unsecured debt, such as credit card debt, medical bills or personal loans. You can’t settle debt acquired from a mortgage or auto loan.

How a Debt Settlement Company Can Help

You can attempt to settle your own debt or hire debt settlement companies like Freedom Debt Relief or National Debt Relief to do the job for you. Both companies assist people with $10,000 or more in unsecured debt and have helped hundreds of thousands of people reduce their debt. Bringing in a third party often increases the chances of successful settlement — but it comes at a cost. Companies typically charge an average of 15–25% of the total debt owed. So if you owe $50,000 in debt and settle for $30,000, you will also owe the debt settlement firm a minimum of $7,500.

How It Works

If you decide to tackle it yourself, you’ll contact your creditors to explain your situation and offer to pay a lump sum to settle your outstanding debt. You’ll probably need to talk to more than one person within a company, and it could require ongoing negotiations. 

If you hire a debt settlement company, they’ll handle the negotiation. The firm may have you stop paying and instead put the money into a separate savings account. This could negatively affect your credit score, but it also gives the company leverage to negotiate. (If the creditors think you’ve completely stopped paying your debts, they may be more willing to settle.)

Here’s how debt settlement generally works:

• Assessment: You and the debt settlement company evaluate your finances to decide on a realistic proposal for the settlement.
• Negotiation: You or the company contact the creditor to make the settlement offer. This step could involve back-and-forth discussions to reach an agreement.
• Agreement: If the creditor accepts the offer, they create a formal agreement that both parties sign. This agreement outlines the terms, including the settlement amount and payment deadlines.
• Payment: You pay the agreed amount, either in a lump sum or structured payments over a short period.
• Debt Resolution: Once you make the final payment, you are debt-free, and the creditor reports the debt as settled.

Risks of Debt Settlement

Though it has its appeal, it also comes with a great deal of risk. For example, finding a reputable debt settlement company can be difficult and costly. It could take three or four years before you and the creditor come to an agreement. Handling it on your own can be time-consuming and stressful, and either scenario could do serious damage to your credit score.

Here are some of the most prominent risks of debt settlement:

• Costly fees: Third-party debt settlement firms charge 15–25% of the debt originally owed. Though they can’t charge these fees until the debt is settled, it means you’ll end up paying quite a bit more than the amount you settled upon with your creditor. 
• Credit score damage: Because most debt settlement companies tell you to stop making payments during the negotiation process, your credit score may take a big hit. Even though it’s settled, it can leave a lasting stain on your credit score.
• Time-consuming process: It takes several years to negotiate debts and build up the money needed to pay the lump sum — even longer if you have many creditors. 
• Tax implications: Any forgiven debt totaling more than $600 is taxable. That means you’ll also owe money to the IRS when you settle.
• Failed negotiations: There’s always the possibility your creditors won’t agree to settle. If you stop making payments in your attempts to negotiate, your creditor could even sue you.

Alternatives to Settling

Debt settlement certainly isn’t for everyone. If you want to avoid it, consider pursuing a lower-risk option. For example, credit counseling can help you create a realistic debt management plan. Likewise, debt consolidation allows you to combine your debts into a more manageable loan and even reduce the total interest you owe.

Bankruptcy could make sense as a last resort, because it can help you move on from debt sooner than debt settlement.

The Bottom Line

On the surface, debt settlement can seem like an appealing way to tackle debt repayment. But once you understand the risks, it’s not always the best option. It can take years to negotiate and doesn’t come with guaranteed success. In fact, you may end up owing more because of late fees and interest rates accrued throughout the process. It’s important to understand the pros and cons before you dive in.