What is Debt Settlement?

what is debt settlement

Debt settlement is an option for those deeply in debt. It's a legal way to pay less than you actually owe, usually through an intermediary, by reaching an agreement with your creditors that sets a more reachable target to pay them off.

While entering into a debt settlement agreement can be an option to prevent bankruptcy, it isn't as simple as just having a lender say you don't owe as much as you used to. The benefit of doing so comes with different costs.

Why it Exists

why settlement

Whether you owe $5,000, $10,000 or $50,000, if you're so far over your head in debt that you can't make your minimum payments, creditors would rather collect something from you rather than nothing. Settlement provides an option for consumers to take a step, short of bankruptcy, and still satisfy their debts, even if not in full.

How it Works

how it works

While it is possible to negotiate with a creditor on your own, typically, a consumer who is unable to pay his or her debts would work through a debt settlement company. These companies have experience negotiating with creditors and have a good idea of how much they will be able to shave off of the total owed.

The consumer pays a fee to the debt settlement company. However, federal telemarketing laws prohibit those fees from being collected in advance of a settlement being negotiated. And the American Fair Credit Council, the industry association, only permits its members to collect fees after settlement is reached.



Settlement companies can assess fees using several different models.

Some will charge a percentage of the overall debt -- usually between 13 percent and 20 percent. So, if you owe $20,000, you could end up paying a fee of $2,600 to $4,000.

Another way the companies assess fees is based on how much they reduce your debt. Those fees can be as high as 35 percent of the reduction, according to the National Foundation for Credit Counseling. If your $15,000 debt was cut in half and the fee was 30 percent, you would pay the company $4,500.

An additional option is to pay the company a monthly fee that ranges from about $20 a month to $90 a month for as long as you're in the program.



How you pay the debt and the fees to negotiate the settlement is a vital part of the process. Often, the debt settlement company will ask the consumer to stop paying his or her bills and stop accumulating debt.

Once in the program, the consumer pays in a specific amount per month to the settlement company. The company holds that money in a separate account, allowing it to accumulate until it grows large enough to begin to be used to satisfy debts and pay the fees.

It typically takes several months before the first settled debt is paid off. The American Fair Credit Council says it generally takes take two to four years to complete a settlement program, depending on how much money is owed and how much money the consumer can pay into the account.

Your Credit

credit after settlement

Settlement can have a significant impact on your credit score and the ability to borrow going forward. Payment history accounts for 35 percent of your score from FICO, the company that produces the majority of credit scores used by lenders.

If you're already delinquent on your bills by the time you consider settlement, you'll not be as deeply affected (your credit is already damaged.) But the process of halting payments -- while it is the way the settlement company can pay off the agreed-upon amount -- can mean showing month after month of late payments on your credit history.

Once your debts are satisfied, they will show that they were paid through an agreement -- documenting that while you no longer owe anything, you did not pay the full amount that was owed.

Tax Implications

tax implications

While seeing your debt reduced is no doubt a relief, it is important to know beforehand another bill could be coming when it is over. The Internal Revenue Service considers forgiven debt as income, so that should be kept in mind as something that will have to be addressed later.


settlement alternatives

Credit counseling, making only minimum payments, getting a home equity or other debt consolidation loan, or filing bankruptcy all are alternatives to debt settlement.



According to the American Fair Credit Council, debt settlement is the speediest and least expensive way to resolve a debt. Using the example of a $30,000 debt, it would take three and a half years with settlement, five for credit counseling, nearly 22 years paying just minimum payments and 10 years using a home equity loan. Debt settlement, even with the fee, would cost about $23,000 on that $30,000 -- while the other options range from $38,000 to $52,000 because they include the full debt plus interest.



Debt settlement doesn't always work. Indeed, well under half of all those who enter a settlement program will end up with their debt eliminated, according to the Center for Responsible Lending.

Some companies make unrealistic claims of having 100 percent success, or close to it. The Government Accountability Office, in an investigation of the industry, found that some consumers dealing with unscrupulous companies ended up paying more than they owed before trying to settle their debt.

Some studies of the industry revealed that only a small percentage of consumers successfully had 75 percent or more of their debt settled.

Between 13 percent and 25 percent of those who enrolled in a debt settlement program end up filing for bankruptcy, according to the Center for Responsible Lending.


settlement tips

The Consumer Financial Protection Bureau suggests not working with a debt settlement firm that engages in the following practices:

  • - Billing for fees before a debt is settled
  • -Claiming they have access to a new government program that helps consumers out of jams
  • -Making guarantees that your debt will be eliminated
  • -Telling clients to not even communicate with a creditor
  • -Promising they can halt all calls from debt collectors and end any lawsuits


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