Debt Settlement: How It Works, What It Costs and the Risks

Debt settlement means getting a creditor to accept less than you owe as payment in full. You can try it yourself, or you can pay a company to do it. It’s mostly used for large unsecured debts, like credit cards, when paying the full amount isn’t realistic. It can reduce what you owe, but it comes with real risks, and it’s usually described as a last resort. Here is how it works, what it costs and what to weigh first.

The short answer

Settlement can lower a balance, but it’s slow, it isn’t guaranteed, and it can hurt your credit and lead to collections or a lawsuit. Fees and taxes can also eat into the savings. If you can repay what you owe with some help, such as a lower rate through a consolidation loan or a nonprofit plan, those routes are generally easier on your credit. See how the options compare.

How it typically works

1. You enroll and list the debts you want to settle.
2. You make monthly deposits into a dedicated account that you own.
3. You usually stop paying the enrolled creditors. Most settlement companies ask you to, so the money can build and creditors have a reason to negotiate. This is the riskiest part.
4. The company negotiates. When enough has been saved, it offers a lump sum to a creditor. If the creditor accepts, the payment comes from your account.
5. The company’s fee is paid after a debt is settled.

Because the savings have to build first, this often takes a few years.

What federal rules say about fees

The FTC’s Telemarketing Sales Rule covers for-profit companies that sell debt relief by phone, including when you call them in response to an ad. Under it, a company can’t charge a fee until it has settled or changed the terms of at least one of your debts under an agreement you’ve accepted, and you’ve made at least one payment on it. The fee must also be proportional to the debt settled, and money you set aside must generally be held in an account you own and control. Many states add their own rules.

If a company asks for a fee before it has settled anything, treat that as a red flag. See how to choose a debt relief company.

A worked example

This is an illustration with made-up numbers. It isn’t a typical or promised result. Creditors decide what they will accept.

• You enroll $20,000 in card debt across four cards.
• Suppose each creditor settles for 50% of the balance: $10,000.
• Suppose the company’s fee is 20% of the enrolled debt: $4,000.
• You pay about $14,000 in total, or 70% of what you enrolled.
• If the $10,000 that was forgiven counts as taxable income, and you’re in an example 22% federal bracket, the tax could be about $2,200. See taxes on settled debt.

Now add what the example leaves out. While you weren’t paying, late fees and interest may have increased the balances. If one creditor won’t settle, that debt is still yours. If a creditor sues, costs can go up further.

The risks

The CFPB lists these risks of working with a settlement company:

• Late fees and interest. If you stop paying, you’ll usually owe more.
• Collections and lawsuits. Creditors and collectors may step up their efforts and may sue.
• Credit damage. Missed payments and settled accounts can hurt your score and your ability to get credit.
• Creditors that refuse. Some won’t work with settlement companies, or won’t settle at all.
• Expensive fees.
• Taxes. Forgiven debt can be taxable income.

Who it may suit

• You have a large amount of unsecured debt, like credit cards, and a real hardship.
• You can’t realistically repay the full balance, even at a lower rate.
• You’re already behind, or about to be, and you understand the credit and legal risks.

Who should look at other options first

• You can afford to repay the debt in full with a lower rate. Look at debt consolidation or a nonprofit debt management plan.
• Your debt is mainly secured, like a mortgage or car loan. Settlement companies generally focus on unsecured debt.
• You have federal student loans, which have their own relief programs.
• You haven’t yet tried talking to your creditors about hardship options yourself.

This article is for general information and isn’t financial, tax or legal advice. Examples are illustrations, not offers or promised results. The sponsored option on this page is paid advertising. See our advertiser disclosure.