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How Debt Settlement Works

Step 1

The first step is deciding whether to hire a debt settlement company or lawyer to negotiate a settlement. You could do this yourself. The goal is to reduce significantly the amount you pay. Experience helps. So does having enough money to make a lump-sum offer. Start saving immediately.

Step 2

Next, meet with the original lender, plead for mercy and ask if they’re willing to settle. If your account is more than six months overdue, the debt likely has been turned over to a collection agency, who has the opposite goal: They want to get as much money from you as they can.

Step 3

It could take three years to save enough money to make an offer. Usually, you are asked to stop paying creditors and instead send monthly payments to your representative to build an account. Meanwhile, interest charges on your debt grow and your account balance grows with it.

Step 4

It’s time to make an offer. Be patient. Creditors have no obligation to accept debt settlement offers. This could take months, maybe years. If the creditor accepts, get it in writing. Also, ask the creditor to send the major credit bureaus notice that the debt has been settled.

Step 5

Now, see if you saved money. Debt settlement companies usually charge 15% of the amount owed or 25% of the amount saved. Lawyers could charge an hourly rate or standard fee. There also are taxes owed to the IRS on the amount forgiven. It is not a sure thing you came out ahead.

Benefits of Debt Settlement

There are some very obvious benefits to debt settlement, especially if you have grown frustrated at an inability to reduce or eliminate credit card debt.

  • The amount you pay will be reduced, sometimes by as much as 50%. Don’t count on the final number being that attractive, but that is the goal.
  • Settling the debt could keep you from being sued or having a court judgment go against you.
  • The nightmare of phone calls from collection agencies will end.
  • It may be the best choice for solving your credit card debt and keep you from having to file for bankruptcy.

Types of Debts Eligible for Settlement

Credit cards and medical bills are ideal for the debt settlement process because if the cardholder files for bankruptcy, the card company or medical facility could get nothing. The Federal Reserve Board says that 7.1% of credit card debt was 90 days past due in Q4 of 2016. The Fed categorizes that debt as “seriously delinquent,” which makes it eligible for debt settlement. About 26% of U.S. adults had trouble paying medical bills in 2016, which also are eligible for debt settlement.

Federal student loans are another story. It’s extremely difficult, to reach a debt settlement. If you have defaulted, the government allows a collection agency to accept a lump-sum payment under three conditions: A) You pay the balance of the loan and interest, but not the collection agency charge; B) You pay the principal plus half the unpaid interest; or C) You pay 90% of the remaining principal and interest.

Private student loans, usually issued by banks, are a better target for debt settlement than federal student loans.

Credit Cards

Medical Expenses

Private Student Loans

Mortgage "Short Pay" Balances

Personal Loans

Utility Bills

Apartment Leases

Cell Phone Bills

Auto Repossession Balances

Stacked Credit Cards

Who Qualifies for Credit Card Settlement?

Credit card companies usually do not have specific guidelines. However, good candidates are usually those who can't afford their monthly payments. Credit card settlement offers debt relief without the stigma or harm of bankruptcy.

What if Creditors Won't Settle?

Creditors have no legal obligation to negotiate an outstanding balance on credit cards or other loans. But they can often recover more funds through debt settlements than other collection methods like hiring a collections agency or attorney.

Can I Settle a Debt for Less than I Owe?

The quick answer is: Yes! The whole goal of debt settlement to pay less than you owe and that is what all the debt settlement companies promise will happen.

The good debt settlement companies will have a long enough track record to tell you how much you can expect to pay and about how long the process will take.

It’s actually possible to do this yourself, but that could be very risky if you’re not experienced at driving a hard bargain. The creditor – or, more likely, the debt collection agency – has done this plenty of times and could use intimidating tactics to scare consumers into paying the full tab.

That’s where the debt settlement company stands out. They have enough experience not to be intimidated and to negotiate a settlement that will provide real savings and an opportunity to start over.

But it comes with a cost and that price is not only money.

The process typically takes 36-48 months for the consumer to put enough money into an escrow account for the debt settlement company to make a competitive offer. During that time, interest and late fees will make the total grow, sometimes in alarming amounts. Brace yourself for that.

When the debt is finally settled, there is another cost: damage to your credit. Your credit report and credit score will be stained for seven years, showing the account as “settled” meaning the debt was not paid in full. Your credit score will take a hit anywhere between 100-125 points because of that.

That means, the next time you look for a loan or line of credit, the lender will see that and factor it into the decision of whether to take a chance on lending you money again.

Debt Settlement Companies

One way to resolve your credit card debt or other debt is to enlist the help of a debt settlement company. Debt resolution companies often are experienced at negotiating with creditors and may have relationships with major creditors, specifically credit card companies.

The first step in the debt settlement process is for a consumer to reach out to a reputable company that can help. These debt arbitration firms are staffed by credit counselors, people who are accredited in analyzing personal finances. They also have a keen understanding of the current marketplace, including how and why creditors will negotiate a settlement.

Once your finances are detailed, the counselor will check the totality of your debt and then draw up a settlement plan. That plan will be presented to you. It should include details about your monthly payment plan and how the settlement company profits from the transaction.

By resolving your debts, an arbitration company can earn its money in several ways. It should receive fees of a scheduled dollar amount, a percentage of the debt you want settled or an agreed-upon percentage of the amount you save through settlement.

Debt Settlement Scams

There are scammers in every business and debt resolution is no exception. Companies make promises they can’t keep; take money they aren’t owed and disappear with the consumer’s problem not solved.

Here are some warning signs of possible scams when dealing with debt settlement:

  • Promises or guarantees that they can settle your credit card debt for less than what you owe. Companies do not have to accept settlement offers so there can’t be a “guarantee.”
  • Suggests you will pay only “pennies on the dollar” of the amount you owe.
  • Doesn’t alert you to the failure rate for many consumers who drop out of the program before their debts are settled.
  • Asks for fees before it settles your debt. Never pay any fees until after the debt has been settled.
  • Tells you to stop paying creditors or communicating with them, but doesn’t tell you the serious consequences of those actions.

If you see these red flags when dealing with a debt settlement company, don’t just walk away … run!

Finding the Right Debt Resolution Company

The Federal Trade Commission (FTC) suggests you look for a number of additional features in a debt resolution company to determine its legitimacy. These features ensure that a company is fair, transparent and professional.

Creditors have no legal obligation to consider any settlement deal, so a debt resolution company cannot honestly ensure an agreement.

A good debt settlement company will:

  • Disclose all program fees and costs before you sign up for a debt resolution program
  • Have easy-to-understand written policies about its debt resolution program
  • Give you an estimate of how many months or years it will wait before making an offer to each creditor
  • Estimate its intended results, but never guarantee a specific settlement amount
  • Tell you how much money you must save up before it will begin making offers to your creditors
  • Send all resolution offers to you for your approval

Preparing Yourself for Debt Settlement

You’ll start the process by putting away money in preparation for debt negotiations. Your settlement company will tell you the total amount you need to save in advance. You’ll make a monthly payment into a dedicated bank account for several months or years, depending on your monthly budget and anticipated amount to be resolved. The account will be in your name and should be insured by the Federal Deposit Insurance Corporation (FDIC). It will be overseen by a trustee or account administrator.

Negotiating Your Debt

As you build up your account, this money will be used to bargain with your creditors on your behalf. You will have the final say on the terms and how your money will be used to pay off the negotiated amount before accepting an agreement. Once those negotiations are successful, your debts will get paid off one by one.

Signing a Credit Card Settlement Agreement

After you come to an agreement on a credit card settlement, put all arrangements in writing for your records. Be sure you and your credit card company sign the agreement. At this point, the account administrator will be responsible for transferring funds from your account to pay your creditor.

Tax Obligations

Speak with a tax professional if the debt amount covered by the settlement is more than $600. If so, you likely will be required to pay income taxes on that amount because the Internal Revenue Service can consider forgiven debt as income.

How Debt Settlement Impacts Your Credit

It’s important to know that your credit scores have already declined if you’re at the point of resolving your credit card debt or other debt. Although this can be stressful, your top priority should be to get out of debt and get your finances back on track.

Talk to your credit card company about whether it will report your agreement as a settlement to the credit bureaus. If so, that settlement could appear on your credit report for about seven years and may damage your credit score. Ask your credit card company to report the settlement as “paid in full” instead. Once your debts are settled and wiped away and you are keeping your financial house in order, your credit scores will move up.

Alternatives to Debt Settlement

Don’t panic if your creditors won’t settle. You have other debt options: Credit counseling, debt management, debt consolidation, and, in extreme cases, bankruptcy.


In debt consolidation, a borrower takes out one big loan to pay off smaller debts, typically achieving a lower interest rate in the process. A debtor will pay one bill every month instead of several bills, but if they are unable to pay the consolidated, secured debt, there is no more wiggle room.

Debt Management Plans

In credit counseling, agencies can set up low-interest debt management plans so that borrowers can pay off unsecured debt over time. A debt management program (DMP) reduces your monthly payments so you can eventually pay off your debt in full.


Personal bankruptcy should always be considered the last resort — and the worst option — for anyone battling debt problems. It will negatively affect your credit, prevent or delay foreclosure on a home and lead to repossession of a car. In addition, filing for bankruptcy can be complex and costly.

About The Author

Bill Fay

Bill “No Pay” Fay has lived a meager financial existence his entire life. He started writing/bragging about it in 2012, helping birth Debt.org into existence as the site’s original “Frugal Man.” Prior to that, he spent more than 30 years covering the high finance world of college and professional sports for major publications, including the Associated Press, New York Times and Sports Illustrated. His interest in sports has waned some, but he is as passionate as ever about not reaching for his wallet. Bill can be reached at [email protected].


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