What Is Debt Settlement and How Does It Work?

Debt settlement is one of the most advertised forms of debt relief, and one of the most misunderstood. In simple terms, it means getting a creditor to accept less than you owe as payment in full. You can try it yourself, or pay a company to negotiate for you. Here’s how it works, and what to know before you consider it.

How a settlement program works

1. Enrollment. You list your unsecured debts, usually credit cards, and the company reviews your situation.
2. Saving. You make monthly deposits into a dedicated account that you own. In most programs, you stop paying your creditors during this time, so the money can build up.
3. Negotiation. When there’s enough saved to offer a lump sum on one debt, the company negotiates with that creditor.
4. Settlement. If the creditor agrees, the settlement is paid from your account, and the company collects its fee for that debt.
5. Repeat for each enrolled debt, which often takes several years.

What the rules say about fees

Federal rules under the FTC’s Telemarketing Sales Rule protect you here. According to the FTC’s guide for businesses, a debt relief company can’t collect any fee until:

• It has settled or changed the terms of at least one of your debts,
• You’ve agreed to that settlement, and
• You’ve made at least one payment to the creditor under it.

The dedicated account must be at an insured financial institution, the money in it is yours, and you can withdraw from the program at any time and get your money back, minus fees already earned, within seven business days. Before you sign up, the company must tell you how long it will take, what it will cost, and the negative consequences.

If a company asks for a fee upfront, walk away. See 7 signs a debt relief company is a scam.

The risks to weigh

• Results are not guaranteed, and not every debt or creditor is eligible. Some creditors refuse to negotiate with settlement companies.
• Settlement programs charge fees, often a share of the debt enrolled or the amount saved. Providers may not charge them before settling a debt.
• Stopping payments has consequences. You can face late fees, penalty interest, collection calls, damage to your credit score and possibly lawsuits. The CFPB warns that settlement may leave you deeper in debt than when you started.
• Forgiven debt may be taxable income. The IRS says canceled debt is generally taxable, with some exceptions, such as insolvency. You may receive a Form 1099-C. Check with a tax professional.
• You might not finish. If you can’t keep up deposits, you may end up with some debts settled, others not, and a lower credit score.

Who considers it

People who look at settlement are usually already behind on large credit card or other unsecured debts, with no realistic way to repay the full amount. It doesn’t apply to secured debts like mortgages or car loans, or usually to federal student loans.

Can you settle a debt yourself?

Yes. You can call a creditor or collector yourself and offer a lump sum, without paying a company’s fees. If you reach a deal, get it in writing before you pay, and make sure it says the payment settles the account. Settling yourself has the same credit and tax effects.

How settlement affects your credit

Missed payments during the program are reported, and settled accounts are usually marked as settled for less than the full balance. Both are negative and can stay on your report for up to seven years, according to the CFPB. Read how debt relief affects your credit score for a side-by-side view, and how to rebuild credit after debt problems for what comes next.

Alternatives to compare first

• Nonprofit credit counseling and a debt management plan, where you repay in full, often at lower interest rates.
• A debt consolidation loan, if your credit allows a lower rate. See debt settlement vs. debt consolidation.
• A payoff plan with a tighter budget.
• A free consultation with a bankruptcy attorney if the debt is far beyond what you can repay.

Questions to ask any settlement company

For a fuller checklist, see 10 questions to ask before you sign up for debt relief.

• What are all your fees, and when exactly are they charged?
• How long do you expect my program to take?
• Which of my creditors are known not to work with you?
• What happens if a creditor sues me during the program?
• What happens to my money if I cancel?

The bottom line

Debt settlement can reduce what you repay on some debts, but it comes with real costs: fees, credit damage, possible lawsuits and possible taxes. Compare every option, read the agreement, and talk to a nonprofit credit counselor before you commit.

Sources: FTC: Debt Relief Services & the Telemarketing Sales Rule · CFPB: what is a debt relief program · CFPB: how long negative information stays on your report · IRS Topic 431: canceled debt