Debt Settlement

By Mike G.

Debt settlement means trying to get your creditors to accept less than you owe, usually through a company that negotiates for you. It’s the riskiest way out of debt covered on this site, so the risks come first.

The risks

• Your credit takes serious damage. Settlement programs usually have you stop paying your creditors while money builds up in a savings account. Missed payments, late fees and accounts sent to collections hurt your credit, often badly.^[1]
• Your debts grow while you wait. Interest and late fees keep adding up on accounts you’ve stopped paying.^[1]
• Creditors don’t have to agree. Some may refuse to work with a settlement company, so some of your debts may never be settled.^[1][5]
• You can be sued. A creditor that isn’t being paid can take you to court, which can lead to wage garnishment.^[1]
• Forgiven debt can be taxed. The IRS generally treats canceled debt as income, so a settlement can come with a tax bill, unless an exception such as insolvency applies.^[2]
• Many people don’t finish. Many have trouble keeping up the deposits long enough and drop out.^[1] Dropping out can leave fees paid on debts already settled, the rest still owed, and late payments on your credit report.

How it works

1. You enroll with a debt settlement company and usually stop paying the enrolled creditors.
2. Each month you deposit money into a dedicated account. Under federal rules for companies that sell by phone, the money is yours, the account is run by a company not tied to the settlement company, and you can withdraw it at any time.^[3]
3. Once enough builds up, the company offers a creditor a lump sum for less than the balance.
4. If the creditor agrees and you approve the deal, the account is paid from your savings and the company takes its fee.

You can also negotiate with a creditor yourself, without a company or its fees. On an old debt, a payment or written acknowledgment can restart the time limit for a lawsuit in some states.^[1]

Who it might fit

Settlement is sometimes considered by people with large unsecured debts who can’t afford a debt management plan, want to avoid bankruptcy, and can save a lump sum. For most people in that position, a nonprofit credit counselor or a consultation with a bankruptcy attorney is a better first conversation. Both can explain options with fewer risks.

What it costs

• Settlement company fees, usually a percentage of the debt enrolled or of the amount saved. Companies that sell by phone can’t charge a fee until they’ve actually settled a debt and you’ve made at least one payment under that settlement.^[1][3]
• Account fees for the dedicated savings account
• Interest and late fees that build up while you aren’t paying
• Possible taxes on the forgiven amount^[2]

Add all of these up when a company quotes you a savings figure.

How it affects your credit

This is where settlement costs the most. Months of missed payments, then accounts reported as settled for less than the full balance, can drag your score down significantly. Most negative information, such as late payments and accounts sent to collection, can generally be reported for up to seven years.^[4]

Red flags

• Fees charged before any debt is settled. Companies selling by phone aren’t allowed to do this.^[3]
• Guarantees that creditors will settle, or that your debt will be cut by a set percentage
• Being told to stop talking to your creditors, or not being told about the credit, lawsuit and tax risks
• Claims of a “new government program” to pay off credit card debt^[1]
• Pressure to enroll before you’ve compared other options

Alternatives to compare first

• Credit counseling and debt management plans: you repay in full, often at lower rates, without stopping payments.
• Debt consolidation: if your credit still qualifies you for a lower rate.
• Bankruptcy: a legal process with court protection from creditors.

Frequently asked questions

Sources