Is Debt Settlement Worth It?

Find out if debt settlement is worth it for you. Weigh the pros of settling your debt for less than you owe with the risk of damaging your credit.

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If the red ink of your financial baggage has the prospect of bankruptcy looming large in your legend, you might consider a debt settlement plan that will allow you to pay less than what you owe.

It sounds good, doesn’t it? It looks good. It could even feel good if it gets you back on the path to solvency. So, yeah. Look into debt settlement when the bankruptcy wolves are at your door.

But make certain it’s a long, hard look before you sign up, because debt settlement doesn’t work for everyone mired in money misery. A 2023 Better Business Bureau study found that nearly half of the people who enter debt settlement plans drop out before they’ve finished their payments.

There are critical factors to consider and serious pitfalls to avoid in a process that promises plenty but delivers something less than that and – oh by the way — is full of scammers. Debt settlement might be a suitable way to manage your overwhelming debt, but it could also drive you even deeper into a financial hole, bottom out your already-damaged credit score, and put you in legal peril.

So be careful. Debt settlement is risky business. Check into all your other options before you go there.

What Is Debt Settlement?

The key feature of debt settlement is clearing your debts by paying back less than what you owe. That’s why it can seem like an enticing option. You or, more frequently, a company you hire to negotiate with your creditor or the debt collector, try to reach an agreement to accept less than you’re currently obligated to pay.

How much less? The percentage varies from lender to lender depending on their own financial needs and their assessment of your reliability. Some debt settlement companies claim they can arrange as much as a 70% reduction in what you owe, though it’s wise to have more than a few grains of salt on hand when you hear a promise like that. A more realistic outcome is around 25%-30% of your debt, but some lenders – if they agree to debt settlement at all – won’t negotiate beyond 10%. Whatever settlement you reach, it should provide at least the prospect of some financial relief for you, as well as a start to rebuilding your credit and a way to avoid bankruptcy.

A creditor isn’t under any obligation to agree to a settlement, which begs the question: Why would he or she take less than what you owe? Here’s the answer: Because the alternative might mean getting nothing whatsoever from you. That’s why negotiations are so important.

You can try to negotiate with your creditor or creditors by yourself, but it can be a drawn-out, aggravating, exhausting process and could require bargaining skills you might not have. Most debt settlement negotiations are done through for-profit companies that charge a fee of anywhere from 15% to 25% of the amount it is claiming to save you.

How Does Debt Settlement Work?

Once you’ve engaged with a debt settlement company – it might refer to itself as a debt relief company or a debt adjustment company – it begins to work on your behalf by discussing with your creditors some alternatives to your current debt payments. The goal is to reach a new agreement that lowers how much you owe, or perhaps arrange a payment plan more suitable to your financial situation.

If you are in serious debt to multiple creditors, separate agreements need to be negotiated with each one.

To meet your new, reduced debt obligation, you pay the settlement company a fixed monthly amount that it in turn puts into an escrow account, which means the company holds the money until the account is large enough to satisfy the terms of the negotiated agreement. At the end of the agreement, the debt settlement company pays out the negotiated number in a lump sum. That usually takes 2-3 years, though it might be longer depending on the size of your debt and the willingness of your creditor to work with you.

Once the new amount of debt has been paid, it shows up as ‘settled’ on your credit report and stays there for seven years. There also is a negative impact on your credit score of 100 points or more.

A handful of things to know about the process:

  • The negotiations might not succeed: As we mentioned, your creditor isn’t obligated to reduce how much you owe.
  • You have a say: If the settlement company and your creditors reach an agreement on a lower debt amount, you also must agree to it.
  • You might be asked to stop paying your bill: During the negotiations, the settlement company might want you to discontinue payments to your creditor, including your credit card bill, as part of its bargaining strategy. That, of course, could come back to bite you with late fees and extra interest if the negotiations fail.
  • Your monthly escrow payments might begin immediately: The settlement company could require you to make deposits into the account while it is negotiating rather than waiting until an agreement is reached.
  • The fees shouldn’t kick in until an agreement is in place: Usually, the settlement company takes its fee out of your escrow account, but not until you’ve signed off on the newly negotiated deal.

Determining Whether Debt Settlement Suits You

Is debt settlement a good idea? The first order of business in making that decision is coming to grips with how dire your financial situation really is and what other options address it. If less-risky alternatives such as a debt management plan or a debt consolidation loan won’t or haven’t worked, then debt settlement might be the last firewall between you and the blazes of bankruptcy.

But, again, make sure you take stock of where you are before you commit.

As you consider debt settlement, think about:

  • The extent of your struggles to make the minimum monthly payments on your debt. If you’re managing to survive those hassles, maybe you can live without debt settlement.
  • How often you can’t make the payments on your debt. If that’s been a regular occurrence, it can be a point in favor of debt settlement. But remember that you’ll need to put money into escrow every month as part of the settlement plan. You’ll face that obligation every 30 days.
  • The total amount of your unsecured debt. Unsecured debt is the kind that isn’t backed by collateral such as your car or your home. For many people, the biggest unsecured debts they carry are the balances on their credit cards, but it can also be medical bills, student loans or other personal loans. A marker for when debt settlement could become a more appropriate solution is if your unsecured debt total is more than $10,000.
  • Your long-term financial goals. What do you want to do after your debt is gone? Buy a home? Invest in your retirement? Sail around the world? Weigh the importance to you of those sorts of objectives against 2-3 years of debt settlement hardships.
  • Your comfort level with personal bankruptcy. Bankruptcy is painful, long-lasting, expensive, and credit-damaging, but it can provide a second chance to get your finances back together. Does it sound better than the risks of debt settlement?

The range of relief offers from most debt settlement companies is generally between 10% and 50% of what you owe, though – as we noted earlier – some companies promise more than that. So it’s certainly worth investigating as you weigh your options.

The Upsides of Debt Settlement

We’ll start by being Captain Obvious here since we’ve mentioned this a time or two already. When it works, debt settlement allows you to pay a creditor or creditors less than what you owe. You save money! The range of relief offers from most debt settlement companies is generally between 10% and 50% of what you owe, though – as we noted earlier – some companies promise more than that.

When it works and you’ve reached the end of the term of the new agreement with your creditors, you’re ready for a fresh start to your financial life and you can make that new beginning without the baggage of bankruptcy.

In the next few sections, we’ll explore some of the specific benefits of debt settlement.

Help With Negotiating

Are you persuasive? Can you convince people to do things? Are you good at bargaining?

It’s a skill that can be learned, but it takes training. A debt settlement company does it every day. The representative pleading your case to your creditor presumably already knows how to negotiate. He or she should bring expertise you might not have when it comes to communication strategy, planning, emotional intelligence, realistic goal-setting, and other areas critical to striking a deal that will help you.

Opportunity To Reduce Overall Debt

Taking a chunk out of what you owe is an appealing feature when you’re wrestling with how to get out of debt. A study released several years ago by a debt settlement industry group called the American Association for Debt Resolution (formerly called the American Fair Credit Council) stated that the average settlement client had debt of about $27,000, so a settlement agreement for 50% relief would reduce that debt to $13,500. Fees attached by the debt settlement company would add to that last figure, but it represents a significant reduction in overall debt, nonetheless. Remember, though: Those calculations come from the debt settlement industry rather than an independent agency.

Preventing Bankruptcy

There are plenty of reasons to try to avoid declaring bankruptcy. For example, bankruptcy stays on your credit report for anywhere from 7-10 years. It could keep you from getting a new line of credit. It could be an issue when you’re applying for jobs. Co-signers on your loans, such as friends and family, could be liable for repaying those debts.

Debt settlement can be painful, too. It will stay on your credit report for seven years. But its risks might not outweigh the negatives of bankruptcy. Think of it this way: In most cases, bankruptcy should be your last resort, after you’ve determined that debt settlement won’t work.

The Downsides of Debt Settlement

Here’s the rub about debt settlement: The hazards are numerous. They include fees that might make your financial life even more aggravating than it is now. Your credit score will plummet. Your tax bill could rise. You might get hounded by collection agencies and – shudder! – their lawyers. And more. The bottom line: You could end up farther in debt than you were when you started your debt settlement plan.

One of the issues in the debt settlement industry is that reporting requirements are inconsistent across the country, so it’s difficult to find reliable statistics about success rates. Then there are the scams. The Better Business Bureau study we mentioned documented more than 11,000 complaints and almost 900 negative reviews about debt and credit assistance companies in 2023.

That’s why it’s vital that you do due diligence both on the company you hire to work with your creditors and on the other get-out-of-debt options available to you.

Here’s a little more detail on some of the possible pitfalls of debt settlement.

Expensive Fees

Debt settlement companies make money from the help they provide, usually by charging fees in the form of a percentage of your current debt or of the savings they negotiate for you. The range is usually between 15%-25%, and it could be higher. By law, debt settlement companies can’t assess those fees up front, so they shouldn’t come into play until after you’ve reached a settlement agreement. (Be especially wary of a company that wants you to start paying the fee before then!) Those fees can dramatically cut into what you think you’re saving in debt settlement.

Harm to Credit Score

Unfortunately, the credit bureaus always seem to know when you’re in debt settlement. That’s partly because when you pay less than what you owe, the account on your credit report isn’t recorded as paid in full. It’s also partly because your settlement company usually requires you to stop making payments to the creditors with whom they’re negotiating. The payments you don’t make get reported to the credit bureau. And since your payment history accounts for 35% of your credit score, your score could drop by 100 points or more. Plus, late payments stay on your credit report for seven years. Ugh!

Creditors Might Not Agree to Negotiate

Debt settlement only works if both sides want to settle. That doesn’t always happen since creditors are under no obligation to cut you a deal. And guess what? While your settlement company has been trying to negotiate that deal, it’s required you to stop making payments to your creditor. You can be stranded at the altar without a settlement agreement while all those missed payments make a beeline to the credit bureaus.  Your credit score tanks, and you’ve got nothing in the way of debt relief. Double-ugh!!

Tax on Debt Savings

Leave it to the IRS to attach some tax implications. Say your debt settlement company saves you $10,000 on your $20,000 of debt. The IRS generally considers the $10,000 you don’t have to pay to your creditor to be taxable income. It’s money you don’t have, and yet you’ll pay taxes on it as if you’d earned it. Triple-ugh!!!

Risk of Legal Action

We’re back to those payments you stop making on the debt, while your settlement company is trying to it reduced. Maybe your settlement company can get a deal done for you before that account gets turned over to a collection agency. But maybe not. Eventually, you could be looking at a debt collection lawsuit that involves the threat of wage garnishment, more fees, and the cost of your own lawyer to defend against it. That gets us up to quadruple-ugh!!!!

Risk of Increasing Debt

When you stop making payments, the creditor to whom you owe that money likely will add late fees, penalty interest and other charges to the balance of your account. That meter keeps running, meaning you’ll owe even more than you did before you started the debt settlement process. That’ll get ugly fast if your settlement company can’t negotiate an agreement.

The Consumer Financial Protection Bureau warns that penalties and fees on the debts that don’t get settled, along with tax on debts that do, can be more than the savings the debt settlement company gets for you. So now we’re up to … oh, never mind. You get the ‘ugh’ point.

By the way, you can avoid losing money in debt settlement if you’re careful and do your homework. Research several companies who might make settlement offers on your behalf. Get comfortable with how long the process might take. Ask specific questions about costs and know the details. At the end of the day, understanding debt and how it works will serve you well.

Potential Charge-Offs

A charge-off is bad news. It means your creditor has declared the debt to be uncollectable, and so has closed your account and written it off as a loss. You don’t want that. A charge-off is reported to at least one of the credit bureaus and appears in your report, which marks you as a high risk to any entity that might consider offering credit to you in the future. One of your goals with a debt settlement plan is to avoid charge-offs. Trouble is, even in debt settlement, your creditor can designate the amount of your reduced debt as a charge-off. That ain’t good.

Debt Settlement Alternatives

In most reasonable rankings of productive moves you can make to fix your debt problems, you’ll likely find debt settlement and bankruptcy near the bottom as last resorts. They can work for you, but they’re both costly. Even when they’re successful, they both involve a long process before your credit rating gets back into the good graces of recovery. Turn to either one only if you simply don’t see any other way to pay off all your debts in the next five years.

If your problems aren’t quite that distressing, then consider one of the other debt solution options available to people struggling to stay on top of their personal finances. Remember, there is no one-size-fits-all answer, because everyone’s money situation is different. Your financial position is unique. You need an alternative that fits it.

In the next sections, we’ll explore some of those alternatives. Take a look. See if any of them make sense for your case.

Nonprofit Credit Counseling

We just told you there isn’t a one-size-fits-all answer to your money woes, but there is a one-stop-shopping place to figure out what might work best for you. A certified credit counselor from a nonprofit credit counseling agency will review all your options (including the alternatives we’ll detail below along with debt settlement and bankruptcy) with you in the context of your specific financial circumstances, and help you develop a personalized plan to solve your money problems. Plus, the first credit counseling session is free. Why not start there?

Debt Management Plan

Your nonprofit credit counselor can set you up in a debt management program that reduces the interest rate on your credit card debt to around 8%. (Point of reference: The median interest rate for credit cards was three times that — 24.37% — in January 2024, according to Investopedia.) By working with your creditors to reduce interest rates to a manageable level, your credit counselor can fashion a debt management plan for you that can have you free of your credit card debt in 3-5 years, and sometimes sooner.

DIY Debt Settlement

If the risks involved with hiring a debt settlement company to deal with your creditors seem too daunting, you can do it yourself. Eliminating the go-between should cut down on the time it takes for the process to run its course, and you won’t have to pay a percentage of your debt as a fee. In a DIY debt settlement, the negotiations are strictly between you and your creditor.

Personal Loans

It sounds counter-intuitive to take out a personal loan – meaning, take on yet more debt – to help get yourself out of the debt you’re already carrying. But if you qualify, you might find a personal loan that comes with a lower interest rate than what you’re currently paying. If you use that new loan to reduce debts that are costing you more, it might make sense. The key words there are “if you qualify.” Getting personal loans that work for you in this situation will be a function of your current credit score and your debt-to-income ratio, among other factors.

Credit Card Balance Transfers

If you qualify (there’s those words again) for the right balance transfer card, you can use it to pay off what you owe on the high-interest credit cards that likely got you into this fine financial mess in the first place. The right card comes with a very low, or even zero interest rate for an introductory period that can last for 12-18 months. After that, though, the interest rate on the new card skyrockets, so it might not be a long-term fix for your problem unless you can pay off the balance you’ve transferred to it quickly.

Debt Consolidation

This takes the form of a big loan, typically from a bank, credit union or online lender, that you use to pay off your credit card debts. Say you have four credit cards with balances that total $10,000. The debt consolidation loan you take out will match that total to eliminate those card balances. The right loan comes with a lower interest rate than the credit cards were charging you, so you’re saving money. Plus, you’ll only make one payment a month instead of four.

How to Proceed with Debt Settlement

Still think debt settlement is the answer? You might be right, of course. If you’re convinced, there are some guidelines to keep in mind as you move forward. The most important step is to identify a handful of debt settlement companies you can trust with your business. Check with the Better Business Bureau and local consumer protection agencies to see if complaints have been filed about them and look into your state’s licensing requirements to see if the companies you’re considering have the appropriate credentials.

Compare how much each company will charge you for its services. Find out if its fees will be based on your current debt or on the reduced amount after negotiations with your creditor. Ask for a timetable about the process and try to find out if you’ll have to pay taxes on the debt forgiven by the settlement.

You want to be as educated about debt settlement as you can be before you take the plunge, just as you want to be as educated as you can be about your specific financial problems and all the alternatives to address them. Do all that, and you’ll be able to make an informed decision about how to get out from under the debt that’s dragging you down.

About The Author

Michael Knisley

Michael Knisley was an assistant professor on the faculty at the prestigious University of Missouri School of Journalism and has more than 40 years of experience editing and writing about business, sports and the spectrum of issues affecting consumers and fans. During his career, Michael has won awards from the New York Press Club, the Online News Association, the Military Reporters and Editors Association, the Associated Press Sports Editors and the Sports Emmys.


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