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What Is Debt Settlement and How Does It Work?

Written by Allison Martin

Allison Martin is a personal finance enthusiast and a passionate entrepreneur. With over a decade of experience, Allison has made a name for herself as a syndicated financial writer. Her articles are published in leading publications, like, Bankrate, The Wall Street Journal, MSN Money, and Investopedia. When she’s not busy creating content, Allison travels nationwide, sharing her knowledge and expertise in financial literacy and entrepreneurship through interactive workshops and programs. She also works as a Certified Financial Education Instructor (CFEI) dedicated to helping people from all walks of life achieve financial freedom and success.

Updated May 21, 2023​

4 min. read​

what is debt settlement

Are you having trouble keeping up with your debt payments? If so, creditors are likely hounding you, and you desperately need relief to alleviate the added stress. A debt settlement plan could be a viable option to resolve your debts and take the first step towards restoring your financial health.

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What Is Debt Settlement?

Debt settlement refers to the act of settling your outstanding unsecured debt (like credit card debt) for less than what you owe. You can hire a debt settlement company to negotiate with creditors on your behalf or work directly with them to settle your debt.

How a Debt Settlement Program Usually Works

Here’s a step-by-step breakdown of how debt settlement works:

1. Dedicated Account to Build Funds

The first step is to speak with a debt consultant to discuss your debt goals. They will review your unsecured debts to determine if you are eligible for their program. If you decide to move forward, the debt consultant will create a plan of action that works for your budget and gives you the best chance at achieving your goals.

Upon enrolling in the program, the debt settlement company will require you to make monthly payments into a dedicated account. These proceeds will eventually be used to cover settlements made with your creditors. Ideally, you’d stop making payments to the creditors and use the funds to make timely deposits instead. Doing so could hurt your credit rating but speed up the settlement process.

2. Debt Negotiation Process

The debt settlement company will begin negotiations with creditors once your dedicated account reaches a certain balance. You will continue to make monthly deposits, and your debt settlement company will contact you each time they reach a settlement agreement with the creditor.

3. Accept Debt Settlement Offer

Before an account is settled, you must review the terms and approve the transaction. If you sign off, funds are sent to the creditor from your dedicated account to settle the account.

4. Complete Program Payments

Continue making monthly payments per the terms of the initial agreement and until the enrolled debts go through the negotiation process.

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Debt Settlement Benefits

If you’re overwhelmed by debt, here are some reasons why debt settlement could be worthwhile:

  • Substantial cost-savings: The debt settlement company could work to reduce your balances to a fraction of the original amount.
  • Simplifies the repayment process: You’ll only make a single payment to a dedicated account each month instead of paying each creditor.
  • No interest charges: Debt settlement companies don’t charge interest because you’re not actually borrowing money.
  • Accelerated repayment: Some consumers who enroll in debt settlement programs settle their debts in just 24 to 48 months.
  • Helps avoid bankruptcy: If you’ve considered bankruptcy, a debt settlement program could help you avoid it by getting your accounts under control.

Debt Settlement Risks

There are also drawbacks to debt settlement you should consider:

  • Steep settlement fees: You will pay a fee, which could be several hundred or thousand dollars, each time a debt is settled.
  • Negative credit consequences: Accounts that are settled report to the credit bureaus as such and could remain on your credit report for up to seven years. Lenders and creditors may see a settled account as a risk and refuse to do business with you. Your credit could also take a hit if you stop paying creditors while enrolled in the program – this is typical and could expedite the settlement process.
  • Tax liability: If a creditor agrees to a settlement, the forgiven amount could be taxable. To illustrate, if you owe $8,000, but the creditor agrees to a lump sum payment of $5,000, the difference of $3,000 could be classified as taxable income. You should check with a tax expert for more information about how this will be taxed.
  • No guarantees: Enrolling in a debt settlement program doesn’t mean all your creditors will budge and accept less than what you owe to settle the accounts. In fact, some could do the opposite.
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Most Common Debt Settlement Costs and Fees

It depends on the debt settlement company. However, you can generally expect to pay 15 to 25 percent of the settlement amount each time an agreement is reached, and most of them don’t charge any upfront fees.

The Differences Between Debt Settlement and Other Options

Considering other options to find relief? Here’s how they stack up against debt settlement programs:

Debt Settlement vs. Bankruptcy

Both options have the end goal of helping you get rid of debt, but there are key differences to be aware of. Your credit score will suffer regardless of which you choose, but the debt settlement process is more drawn out. Generally, you will spend two to four years enrolled in a debt settlement program, and creditors could continue to assess fees and pester you until all the enrolled accounts are settled. But with bankruptcy, collection actions must cease right away if you qualify for Chapter 7 (liquidation of assets) or Chapter 13 (reorganization).

Chapter 7 generally takes three to six months, and you will not be subject to an extended repayment plan. Chapter 13 does require a repayment plan that spans from three to five years, but you’ll only repay a portion of what you owe.

Debt Settlement vs. Minimum Monthly Payments

If you only pay the minimum on your credit cards each month, you could spend several years repaying the balance. However, making timely payments helps preserve your credit health, as payment history accounts for 35 percent of your credit score.

By contrast, settling your debts typically means forgoing payments to creditors and contributing the funds to a dedicated account. The money is then used to pay creditors each time a settlement is reached.

Debt settlement could save you a bundle as you’ll only repay a fraction of the debt, but it could hurt your credit rating. Plus, the forgiven amount could be considered taxable income, which could mean a higher bill at tax time, so it is recommended to get advise from a tax expert.

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Debt Settlement vs. Debt Consolidation

You roll all the balances into a new loan product with a more competitive interest rate when you consolidate your debt. Your credit score could improve if paying off your cards reduces your credit utilization, and you’ll enjoy a single monthly payment instead of several. Depending on the repayment term, you could also get out of debt sooner.

Debt settlement also requires monthly payments, but there are no guarantees that your debts will be settled. Plus, there are flat-rate fees you must pay each time a debt is settled that could be more costly than the amount paid in loan origination fees and interest. And your credit score could drop when you enroll in the program if you stop making payments to your creditors.

Debt Settlement vs. Credit Counseling

Credit counseling is offered by non-profit organizations. The counselors work with you to develop a realistic plan to manage your money, repay debts and improve your overall financial health. However, debt settlement companies are for-profit entities that negotiate with creditors to reduce your debt balances.

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