What Is Debt Settlement and How Does it Work?

Debt settlement is a negotiated agreement in which a lender accepts less than the full amount owed – sometimes significantly less – to legally settle a debt. It can be a viable alternative to bankruptcy, especially if your debts are held by debt collectors, who often buy up debts for nickels on the dollar.

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Can I Settle a Debt for Less than I Owe?

It is possible to settle most debts for less than what is owed, especially those held by debt collection agencies. The whole goal of debt settlement is to pay less than you owe. Getting out from under some fraction of your balance(s) is what all debt settlement companies promise will happen.

Good debt settlement companies — generally, those associated with the American Fair Credit Council (AFCC) and its strict code of conduct — have a track record long enough to reasonably predict how much (or little) you can expect to pay, as well as about how long the process will take.

Greg Regan, partner-in-charge at Hemming Morse’s Forensic and Financial Consulting Services Group reported the following in February 2021:

  • Debt settlement provided, on average, $2.64 in consumer savings for every $1 in assessed fees.
  • Nearly all offered settlements — more than 98% — resulted in a decrease of the client’s debt greater than the accompanying fees.
  • The longer clients participate in a debt settlement program, the more savings they see, on average.
  • Three out of four debt settlement clients settle at least one account within the first four to six months after enrollment.
  • The average client reduced total debt of approximately $30,000 to $35,000 at the time of settlement, by approximately $9,500 after deducting fees.

There’s nothing magical in the debt settlement process, which introduces this wrinkle: It’s possible to run the program yourself and save the settlement company’s fees. However, unless you are committed, disciplined, and experienced at driving an extremely hard bargain, you’ll be assuming incredible risk. The creditor — more likely the debt collection agency that bought the debt — has encountered novice do-it-yourselfers countless times, and knows how to pressure self-represented consumers into paying the full tab.

This is where proven debt settlement companies stand out. Their experience and expertise — not to mention their professionalism — provide a forcefield against intimidation tactics, enabling them to negotiate a settlement that results in real savings and an opportunity to start fresh.

Pros and Cons of Debt Settlement

So, ultimately, you get to restart your personal finance life while saving money, and have professional experts running interference for you. What’s the downside? Glad you asked.

Debt settlement comes at a cost — not just financial, but personal and emotional, too. Just because the debt settlement company provides a safety net somewhere down below, it doesn’t mean you’re not still doing a high-wire act.

Pros of Debt Settlement

  • Your debts will be erased at something less than the total owed.
  • Debt settlement could be the cheapest option when weighed against credit counseling/debt management and making minimum monthly payments.
  • When it’s over, you’ll have a fresh start for your financial life.
  • If successful, you won’t be sued for collection of your debt, and you’ll avoid wage garnishments.
  • You will have avoided potential bankruptcy.

Cons of Debt Settlement

  • You must be patient. The process of funding an escrow account large enough to enable the debt settlement company to make an attention-getting offer to your creditors typically takes 36-48 months.
  • You must be thick-skinned: Creditors will continue to attempt to collect the outstanding debt.
  • The Federal Trade Commission (FTC) reports many consumers have trouble making the monthly payments to their escrow accounts long enough to get all, or even some, of their debts settled, becoming debt-settlement dropouts.
  • Meanwhile, mounting interest and late fees will cause your balance(s) to balloon, oftentimes to alarming totals.
  • There are no guarantees creditors will accept anything less than full payment.
  • Some portion of your escrow account, up to several thousand dollars, will pay for the debt settlement company’s services.
  • Even when you are represented by a debt settlement company, there’s a chance you could be sued for repayment before you can make a lump-sum offer. In some cases, winning creditors may be empowered to garnish your wages or put a lien on your home.
  • When (or if) the debt finally is settled (knock wood), here comes another blow: damage to your credit.
  • Your credit report and credit score will be stained for seven years, showing the account as “settled,” or not paid in full.
  • The pummeling to your credit score will range between 100-125 points.
  • That “settled” designation will be a black mark when you seek a loan or a line of credit; lenders factor it into the decision of whether to take a chance on lending you money again.

Types of Debts Eligible for Settlement

Credit cards and medical bills are ideal for the debt settlement process. If a cardholder teetering on the brink of insolvency files for bankruptcy, the card company or medical facility could get nothing. While credit card balances dipped significantly during the worst of the pandemic, pent-up appetites for spending have sent them surging since late 2020.

The New York Federal Reserve reports only 4.1% of accounts were delinquent at the end of 2021, the lowest in 18 years. Meanwhile, banks writing off debt as uncollectible slipped below 2% for the first time since at least 1985, according to the St. Louis Fed.

But the end of supportive federal programs, including the monthly child tax credit, combined with inflation, could cause those numbers to move in an unpleasant direction.

Consumers facing seriously delinquent credit card debt — 90 days past due — are eligible for debt settlement consideration. Unpaid medical bills, too, are debt-settlement eligible.

Federal student loans are another story. With the moratorium on payments and interest on federal student loans extended through August 31, and outright forgiveness sure to be a campaign issue in the fall of 2022, it’s safe to keep concern about your outstanding balance on a back burner. Just don’t make any important financial or budgeting decisions based on full-blown relief from Washington.

Typically, however, federal student loan balances are highly resistant to debt settlement schemes. If you have defaulted, the government allows a collection agency to accept a lump-sum payment under three conditions:

  • You pay the balance of the loan and interest, but not the collection agency charge.
  • You pay the principal plus half the unpaid interest.
  • 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 rarely have specific guidelines. However, good candidates usually are 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 often can recover more funds through debt settlements than other collection methods, such as hiring a collections agency or attorney.

Debt Settlement Companies

One way to resolve your credit card debt or other debt is to enlist the help of a debt settlement company. As noted earlier, debt settlement (relief/resolution/adjustment) companies often are experienced at negotiating with creditors and may have relationships with major creditors, specifically credit card companies.

The first step in finding the right debt settlement company is by reaching out to a reputable company. These debt arbitration firms are staffed by credit counselors, people 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, then draw up a settlement plan for your inspection and approval. The plan should include details about your monthly payment schedule, as well as 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

Every industry has its scammers, and debt resolution is no exception. Companies make promises they can’t keep, take money they aren’t owed, and disappear with the client’s problem unresolved.

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

  • Promises or guarantees 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.
  • Neglects to 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. This is the reddest of flags. 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, skedaddle pronto.

Finding the Right Debt Resolution Company

Pardon the reiteration, but some aspects of debt resolution cannot be overstated. The best debt settlement agencies are absolutely transparent about fees, have a demonstrated history of superb customer service, and are accredited by a reputable industry watchdog, such as the AFCC.

To provide the best insurance against scam artists, you must do that homework.

The FTC recommends looking for a variety of additional features in a debt resolution company to determine its legitimacy. These features ensure a company is fair, transparent, and professional.

Remember — this is crucial — creditors have no legal obligation to consider any settlement deal, so a debt resolution company cannot honestly ensure an agreement.

As you explore, the FTC urges noting which companies volunteer the following information, and which do not:

  • The funds in the escrow account are yours, and you are entitled to the interest earned.
  • You can withdraw from your balance at any time without penalty (however, this will hinder your progress).
  • The account administrator is not part of the debt settlement company.

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.
  • Provide a good-faith estimate of how many months/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

How to Prepare for Debt Settlement

Once you’ve reached an agreement with your preferred debt settlement company, you begin by making monthly deposits into an escrow account in preparation for debt negotiations. Your settlement company will tell you the total amount you need to save in advance. These routine payments, deposited in a dedicated bank account, may take from several months to a few years, depending on your 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

Once your account has grown to attention-getting proportions, the money will be used to bargain with your creditors on your behalf. Before the agreement is accepted, you will have the final say on the terms and how your money will be used to pay off the negotiated amount. As negotiations succeed, your debts are paid off one by one.

Signing a Credit Card Settlement Agreement

As agreements are reached on credit card settlements, get all the arrangements in writing for your records. Be sure you and your credit card company sign the agreement. When this is accomplished, the account administrator will be responsible for transferring funds from your account to pay your creditor.

Tax Obligations

Speak with a tax professional about the consequences of debt settlement. Because they get a deduction for writing off bad debts, creditors may report this unpaid portion of your original balance to the Internal Revenue Service. The IRS, in turn, will regard your forgiven debt as regular income, and it may affect your taxes.

How Debt Settlement Impacts Your Credit

If you’re at the point of hoping to resolve your credit card debt or other debt through settlement, it’s important to understand your credit scores most likely already have plummeted. (If they haven’t, your situation probably is not desperate; seriously consider other options.)

Although this can be stressful, your top priority should be to get out of debt, ultimately getting 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 begin to recover.

Alternatives to Debt Settlement

At the risk of repeating ourselves, seeking relief through debt settlement comes with risks and zero guarantees. The fact that you’re here suggests you’re still weighing options. Your prudence is commended. Before you leap, review these alternatives:

Debt Consolidation

In debt consolidation, a borrower takes out one large loan (from a bank, credit union, or other lending agency) to pay off smaller debts. The upside: An overall lower interest rate, a single due date, and a date certain when the debt will be satisfied. The downside: Failure to keep up with the loan payment limits the debtor’s future options.

Debt Management Plans

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


Personal bankruptcy always should be considered the last resort — and the worst option — for anyone in a debt struggle. Not only will bankruptcy hammer your credit score, filing can be complex and costly. And if it turns out you attempted bankruptcy before it was, in fact, your last resort, your application may be denied.

Debt Settlement FAQs

For applying their expertise and experience on your behalf, debt settlement companies charge fees between 15%-35% of the amount forgiven. The larger the amount forgiven by the creditor, the larger the fee collected by the debt settlement company.

The range is vast — 30%-80% — and depends on a variety of factors. What’s the debtor’s overall financial situation? How old is the debt? Who is the creditor, the original issuer of the debt, or a collections agency? Who is representing the debtor?

With discipline, patience, and toughness, you can carry off a debt settlement action on your own. Research how your creditors (or debt collectors) handle debt settlement. Build your own dedicated account for paying off accounts. Prepare to negotiate. Contact your lenders and propose a plan to settle your balances.

A debt settlement sticks to your credit report for seven years from its initial delinquency date.

Repairing your credit after debt settlement is the same as it is for consumers whose credit has been in good standing all along: Stay below your credit limit, pay on time, and keep your credit utilization ratio below 30%.

The fact that you have an established debt settlement agreement cannot prevent a creditor for filing a lawsuit. The possibility is small, but not zero. If you have retained a debt settlement company, its agents will continue to negotiate on your behalf.

It doesn’t matter whether you have an active debt settlement agreement. If you are successfully sued by a creditor or debt collector, among the resources they’ll have is the option to garnish your wages. Again, however, the likelihood that you will be sued is small, and in the aftermath of an unlikely lawsuit, the debt settlement company will continue to negotiate.

The difference between debt settlement and debt consolidation boils down to how the debt is repaid and how the program impacts your credit.

The goal of debt settlement is to repay only a portion of the debt that you owe. It involves negotiating with your creditors (either through a debt-relief company or by yourself) and forgoing payments to build leverage. The consequences are that your credit is severely damaged and your debt will increase during the process due to late fees and interest charges.

With debt consolidation, you use a loan or credit card to pay off your current debts, consolidating them into one large debt. Then, you simply make each monthly payment until the balance is paid off. The impact to your credit is minimal because you continue to make payments until the debt is paid in full.

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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