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What Is Debt Settlement and How Does It Work?

Debt settlement is an approach to resolving unsecured debts such as credit cards and medical bills for less than the total amount owed. With debt settlement, you or a debt settlement company negotiates lump-sum payments with your creditors. In exchange for those payments, which are often 40-60% of what you originally owed, the creditors agree to forgive or cancel the remaining balances.

The debt settlement process typically takes 24 to 48 months from start to finish. During this time, you’ll need to build up funds to have enough for a lump-sum settlement offer. Once you’ve accumulated sufficient money, your debt settlement company (or you directly) approach creditors and attempt to negotiate resolutions.

Debt settlement can allow you to resolve debts much faster compared to trying to pay them off in full over many years. However, it can also come with some drawbacks that should be considered.

Key Takeaways

  • Debt settlement allows you to negotiate lump-sum payments to creditors for less than the total amount owed, often 40-60% of the balance.
  • It can provide significant debt reduction but also may negatively impact your credit scores initially and for up to seven years.
  • Debt settlement companies charge fees of 15-25% but provide expertise; you can also attempt to negotiate settlements yourself.
  • Alternatives such as debt consolidation loans and debt management plans exist that may be less negatively impactful to credit.

Pros of Debt Settlement

Reduced Debt Amount

The biggest advantage of debt settlement is the opportunity to reduce your overall debt burden. Settlements frequently resolve debts for just 40-60% of the original balance, which can provide major financial relief and savings.

For example, if you owed $50,000 across multiple credit cards, you might be able to negotiate to pay just $25,000 to settle and have the remaining $25,000 forgiven through debt settlement.

Faster Payoff Timeframe

When you negotiate lump-sum payments rather than trying to pay the full amounts over time, you can potentially become debt-free much faster compared to just making minimum monthly payments on your accounts.

Whereas it might take 10-plus years to pay off $50,000 in credit card debt making minimum payments, you could potentially settle that debt within two to four years through debt settlement negotiations for a fraction of the cost.

Reduced Stress and Peace of Mind 

Having overwhelming debt can take a major emotional toll on you. Debt settlement gives you a pathway to resolve those burdens in a reasonable timeframe, alleviating stress and providing peace of mind once your debts are settled.

Cons of Debt Settlement

Negative Credit Score Impact

One of the biggest drawbacks of debt settlement is the negative effect it can have on your credit scores. Your credit may be impacted due to several factors:

  • Late payments leading up to settlement
  • Accounts being listed as “settled” or “uncollected” rather than paid in full
  • Potential charge-offs from creditors
  • High debt-to-income and credit utilization ratios during the process 

This can make it difficult to qualify for new loans, credit cards, mortgages, housing, and other credit-based services.

Fees for Debt Settlement Companies

If you hire a debt settlement company to negotiate on your behalf rather than handling it yourself, you’ll be charged fees that can eat into your overall savings. Most companies charge upfront fees of a few hundred dollars, plus a percentage of your total enrolled debt, often 15-25%.

So, if you owed $25,000 across multiple creditors, you might have to pay $3,750 to $6,250 in fees to the settlement firm in addition to your settlement amounts.

Negative Credit Reporting

Beyond the initial credit score impact, debt settlement can continue to impact your credit reports and scores for years. Settled accounts can be listed on your credit reports for up to seven years from the original delinquency date on each debt.

While the negative impact fades slightly over time as the settled debts age, these derogatory marks may still serve as red flags to potential lenders, creditors, landlords, and others who check your reports.

Potential Tax Liability

Another downside of debt settlement is the potential tax consequences of having debt forgiven. According to the IRS, debt that is canceled or forgiven may be considered taxable income.

For example, if you settled $20,000 worth of debt for $10,000, you may have to claim that other $10,000 as income when filing taxes. Consult a tax professional to understand the potential tax impacts based on your specific situation.

Risk of Lawsuits

Even if you start negotiating settlements, there is no guarantee that creditors will agree to settle your debts. Creditors can refuse settlement offers and still pursue lawsuits against you in an attempt to collect the full amounts you originally owed them.

Lawsuits and judgments pose further financial and credit risks. If a creditor receives a judgment against you, they may be able to garnish your wages or put liens on your bank accounts or property to collect what’s owed.

Does Debt Settlement Impact Your Credit?

Yes, debt settlement can have a negative impact on your credit scores. The impact starts accumulating well before any debts are actually settled due to the number of late and missing payments required to default.

Once accounts are officially settled, they’ll be listed as such on your credit reports. Settled accounts produce a negative credit score impact because credit scoring models view them as being even worse than debts that were charged-off or sent to collections without being settled. 

Overall, you can expect your credit scores to drop by as much as 100 points or more. And even once settled accounts start aging, they’ll still serve as derogatory marks that get factored into your scores for up to seven years from the original delinquency dates.

The impact of debt settlement can impact your ability to open new credit accounts, qualify for loan approval, obtain a mortgage or auto loan, rent an apartment, and more. While the negative credit impact fades over time as the settled debts get older, it takes diligent credit management to help restore your scores. 

How to Negotiate Debt Settlements

If you decide debt settlement is the best path for resolving your debts, you’ll need to choose between two main options for negotiating.

Use a Debt Settlement Company vs. Negotiating Yourself

The first option is to hire a debt settlement company to negotiate settlements on your behalf. While this option is more hands-off for you, it does come at a cost. Debt settlement companies typically charge around 15-25% of your total enrolled debt in fees.

Your other choice is to attempt to negotiate settlements directly with creditors on your own. This helps you avoid paying the hefty fees charged by companies. However, it requires much more time, effort, and skill to negotiate settlements successfully without professional guidance.

Gather Documentation of Financial Hardship

Whether working with a debt settlement company or handling negotiations yourself, you’ll need documentation to build a case for why creditors should accept reduced lump-sum payments to settle your debts. 

Essentially you want proof of financial hardship. Helpful documents can include:

  • Job termination or layoff notices
  • Pay stubs showing reduced income
  • Major medical bills
  • Divorce decrees
  • Bankruptcy filing notices
  • Copies of outstanding loans and credit card statements

Start Negotiations Early

The sooner you start the debt settlement process, the better leverage you may have with creditors. If your accounts are only recently delinquent, within 90-180 days of late payments, many creditors are often more willing to negotiate reasonable settlements.

However, once debts age significantly past the 180-day late mark, creditors may become less motivated to accept discounted settlements. They would often rather pursue full balance collections at this point through calls, letters, lawsuits, or selling the debt to third-party collection agencies.

Maintain Consistent Communication 

Throughout the debt settlement negotiation process, it’s important to keep the lines of communication open with creditors. Respond promptly to calls and information requests, and provide ongoing status updates on your financial situation. 

Creditors are often more willing to negotiate with debtors who are engaged and responsive, rather than avoiding them entirely. However, don’t provide formal settlement offers or payment details until you’ve finalized an agreement.

Get Settlements in Writing

Once you’ve agreed on settlement amounts and terms with each creditor, you must get the full details of your agreement documented formally in writing. You should never finalize debt settlement agreements or make payments without first receiving written documentation from creditors.

Insist on written settlement agreements that detail the specific amount you’ll pay, the accounts covered, the remaining balances being forgiven, and other terms or conditions involved. This paperwork serves as legal proof to help prevent miscommunications or having creditors later attempt to collect more money.

Alternatives to Debt Settlement 

While debt settlement can allow you to resolve debts for a reduced lump sum, it’s certainly not the only option for dealing with unmanageable unsecured debts. There are a few other potential paths to consider as alternatives:

Debt Consolidation Loan

Instead of negotiating settlements, you could look into obtaining a debt consolidation loan from a bank, credit union, or online lender. With this strategy, you take out one new loan that pays off your various credit card debts, medical bills, and other unsecured creditors.

The goal is to secure a large fixed-rate loan with a lower interest rate than your current debts and affordable monthly payments. This simplifies everything into one monthly payment and can help save on interest charges compared to continuing to carry high-interest credit card balances.

Credit Counseling and Debt Management Plans 

Another alternative is to work with a credit counseling agency that offers debt management plans (DMPs). These agencies provide money management counseling and education. They can help you create a personalized budget and action plan for addressing debts.

If a DMP is recommended, you’ll make a single monthly payment to the credit counseling agency that gets distributed across all your enrolled creditors. The agency has already negotiated set interest rate reductions and fee waivers from major banks and lenders for clients on DMPs.

DMPs typically run for three to five years until your debts are paid off. While you still have to pay your debts in full, you benefit from reduced interest rates, more affordable payments, and the convenience of not dealing directly with creditors. And your credit isn’t negatively impacted like it is with debt settlement.


For debtors in extremely severe financial hardship with no path to pay down debts, bankruptcy may be the last resort option to consider. There are two major types of consumer bankruptcy:

  • Chapter 7 bankruptcy is a liquidation process where your non-exempt assets get sold off and proceeds go to creditors. Remaining eligible debts are discharged.
  • Chapter 13 bankruptcy is a restructuring where you repay creditors through a three to five-year court-approved repayment plan using disposable income. The remaining balances are discharged.

Bankruptcy does allow you to get out from under debt and get creditor harassment to stop. However, it triggers a negative credit score impact and you’ll have it on your credit reports for seven to 10 years.

Debt Settlement FAQs 

Am I eligible for debt settlement?

Some debt settlement companies require consumers to have at least $10,000 in debt to be eligible for their programs. Those with less debt may not be accepted or could be subject to minimum fees.

How long does debt settlement take? 

The debt settlement process typically takes 24 to 48 months from start to finish.

How long do settled debts stay on credit reports?

Accounts listed as “settled” can remain on your credit reports for up to seven years from the original delinquency date with each debt before being removed. This maximum seven-year timeline resets with each debt as it is settled.

Bottom Line 

Debt settlement can help provide major debt relief by allowing you to pay creditors a fraction of what you owe. However, it can also negatively impact your credit scores for years due to missed payments and settled debt reporting.

For personalized guidance, consult with a Credit & Debt financial expert about the best path for resolving your debts while minimizing negative credit impact.

Kelly Baker

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