Debt settlement involves negotiating with creditors to accept less than the full amount you owe. In most cases, you stop making payments on your debts and instead save money in a dedicated account until you have enough to make a lump-sum payment to the creditor.
However, this approach is far from a simple solution. Financial experts generally regard debt settlement as a last resort, given its high-risk nature. It can seriously damage your credit score, trigger collection calls or lawsuits, and may even result in a significant tax bill on forgiven debt.
Before enrolling with a debt settlement company, it’s essential to understand which types of debt qualify, who is most likely to benefit, and the risks involved.
What is debt settlement?
Debt settlement involves negotiating with creditors to accept less than the full balance you owe. In most cases, you stop making payments on your debts. Instead, you’ll save money in a dedicated account until there’s enough cash to make a lump-sum settlement offer to the creditor.
Creditors might agree to accept a reduced payment if they believe you’re unable to repay the debt in full. However, some creditors may refuse to negotiate altogether, leaving you exposed to risks such as a damaged credit score.
What kind of debt can you settle?
Debt settlement generally applies only to unsecured debt — including credit cards, medical bills, and personal loans — but not to mortgages, auto loans, federal student loans, or IRS tax debt.
Unsecured debts are not backed by collateral, meaning your creditor cannot repossess property if you default. Common examples include credit card balances, medical bills, payday loans, retail store cards, and unsecured personal loans.
Because these debts aren’t tied to a physical asset, creditors have fewer ways to recover the money you owe if you stop making payments. This could incentivize them to accept a reduced payment, especially if your account is already in serious default. However, not all creditors are willing to negotiate and settle.
Mortgages and auto loans generally don’t qualify for debt settlement programs because the lender holds collateral. If you stop paying a mortgage, for example, the lender can foreclose on your property to recoup its money.
Federal student loans also generally don’t qualify for debt settlement. Private student loans might, but settlement remains difficult and depends heavily on the lender’s policies and your financial situation.
You’re also out of luck if you owe money to the IRS. While you might be able to apply directly to the IRS for what’s known as an offer in compromise, debt settlement companies cannot negotiate to lower your balances with the federal government.
Many debt settlement companies require you to enroll a minimum amount of unsecured debt, such as $7,500 or $10,000. If you owe less than that, you’re likely better off negotiating directly with your creditors, requesting hardship assistance, or working with a nonprofit credit counseling agency.
Am I a good candidate for debt settlement?
You might be a good candidate for debt settlement if your unsecured debt is truly unmanageable and you’ve already explored other options.
Debt settlement might be worth exploring if:
- You’re already missing payments or about to fall behind: Creditors are usually less likely to negotiate if you’re still current on your accounts. From their perspective, making minimum payments suggests you might still be able to repay. Debt settlement becomes more viable once accounts are at least 90 days past due.
- Your debt is more than what you could realistically repay in three to five years: If your unsecured debt would take several years to pay off — even after major budget cuts — settlement might make sense. This is especially true if your minimum payments are barely reducing the principal because most of your money is going toward interest.
- You’ve experienced long-lasting financial hardship: Job loss, divorce, disability, or a serious medical crisis could make it impossible to keep up with payments.
- You don’t have major assets that creditors could seize: If you don’t own a home with substantial equity, expensive vehicles, or sizable nonretirement investment accounts, creditors have less to pursue if they decide to file a lawsuit against you.
- You can save money for settlement offers: You usually need to set aside money each month so cash is available to offer creditors. If you can’t reliably save, the program could fail before any debts are settled.
- You understand the costs and financial risks: According to the Consumer Financial Protection Bureau (CFPB), debt settlement often comes with expensive fees — typically 15% to 25% of the total debt you enroll in the program. If you stop paying your bills, you can also face late fees, penalty interest, and other charges. And since it can severely impact your credit, you might have a hard time qualifying for a loan or getting approved on a rental application for several years.
Finally, it’s important to understand what debt settlement doesn’t do. It doesn’t stop creditor lawsuits the way bankruptcy can. It can’t force creditors to negotiate. And it won’t erase late payments from your credit report either.
How to prepare for debt settlement
Debt settlement requires more than major credit card debt. You may also need evidence of financial hardship and enough cash flow to fund your settlement account. To determine whether you qualify, a settlement company will usually review your income, debt balances, creditors, and monthly budget before moving forward.
You should also prepare for tax consequences. Canceled debt over $600 is considered taxable income unless an exception applies, according to the IRS. How much you’ll owe depends on your income tax rate: If you’re in the 22% bracket and have $10,000 worth of debt forgiven, that results in a $2,200 federal tax bill.
Some borrowers qualify for the insolvency exclusion when their total debts exceed their total assets. This means you won’t have to pay taxes on forgiven debt, but you’ll need records to support the claim.
You’ll also need patience, as it can take two to four years to complete a debt settlement program. During that time, interest and late fees can accumulate, your credit score can decline significantly, and collection calls can increase.
Before entering into an agreement with a debt settlement company, ask for the fee structure, estimated timeline, and the creditor-by-creditor strategy the company plans to use. Make sure to get everything in writing.
Finally, be aware that there are bad actors in this space. The Federal Trade Commission maintains a list of over 400 companies and individuals banned from participating in debt relief businesses due to legal complaints.
Who should avoid debt settlement?
Debt settlement is usually a bad idea if you have other options available.
If you have good credit and a reliable income, consider a balance transfer credit card, a debt consolidation loan, or a hardship program through your creditor. These options can lower your interest or simplify payments without pushing you into default.
A debt management plan is another alternative worth exploring. Under this approach, a nonprofit credit counseling agency works with creditors to reduce interest rates, waive certain fees, or create a structured repayment plan.
You’ll usually repay the full principal, but payments tend to be more affordable and you avoid many of the risks associated with debt settlement. You can find a list of government-approved credit counseling agencies in each state on the U.S. Department of Justice’s website.