Debt Settlement: How It Works & Is It Worth The Risks

If you're grappling with overdue debt, you might consider whether debt settlement is the right solution. It could be a viable option, depending on how you approach it, whether by enlisting a third-party debt settlement company or negotiating the debt on your own.

Experts caution that using a debt settlement company can be an expensive and risky choice. While a DIY settlement plan might be effective, it can also be challenging to execute.

Continue reading to explore the details of working with a debt settlement company.

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The Basics of Debt Settlement

Debt settlement, sometimes called debt negotiation, involves paying off a portion of your debt in a single lump sum, which is usually much less than the total amount you originally owed.

For borrowers, this approach can offer financial relief and help them start rebuilding their credit. Creditors benefit as well, as they recover at least some of the money they're owed, rather than potentially nothing.

Debt settlement might allow the borrower to avoid filing for bankruptcy, although some experts suggest that, in some instances, bankruptcy could be the better option. Typically, debt settlement is used to address credit card debt, but it may also be applicable to other types of unsecured debt.

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How Debt Settlement Works

Debt settlement managed by a company differs significantly from taking a DIY approach. Here’s an overview of the process when you hire a debt settlement company.

1. Research Debt Settlement Companies: There are many legitimate debt settlement companies in the U.S., and most states require them to be licensed. These companies are expected to follow industry regulations that protect consumers and their finances.
2. Exercise Caution: Be wary of any debt settlement company that promises specific results. For instance, they cannot guarantee that a creditor will agree to a settlement. As you research, check resources like the Better Business Bureau, your state attorney general’s office, and consumer protection agencies like the Consumer Financial Protection Bureau (CFPB).
3. Inquire About Costs: Once you’ve identified a potential company, ask about their fees. If they avoid answering questions about costs, this could be a red flag. Typically, debt settlement companies charge a fee ranging from 15% to 25% of your debt. For example, if you owe $10,000 and settle for $5,000, you might also need to pay an additional $750 to $1,250 in fees.
4. Review Your Finances: These companies often require you to deposit money into a special savings account for 24 months or longer before your debt is fully settled. These payments contribute to the lump-sum settlement. However, keeping up with these payments can be difficult, and failing to do so might lead you to abandon the agreement before the debt is fully settled. Review your budget carefully to ensure you can manage these payments over the required period.
5. Ask About the Timeline: Debt settlement typically takes between two and four years to complete. During this time, you may incur interest and fees from your creditors in addition to the fees from the settlement company. This happens because settlement companies may advise you to stop paying your creditors and instead direct those funds to the special savings account. If you halt payments, you might be contacted by debt collectors or even face lawsuits.
6. Choose a Debt Settlement Company: If you’re aware of the potential risks and still want to proceed, select a company based on your research.
7. Clarify the Details: Before committing to any company, ensure you understand the timeline and the fees involved. Ask how much of your initial payments will go toward the company’s fees and the total amount you’ll end up paying.
8. Understand the Tax Implications: The IRS considers any forgiven debt over $600 as taxable income. So, if you settle a $10,000 debt for $5,000, the $5,000 that was forgiven may be subject to taxes.

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The Risks of Debt Settlement

Debt settlement can be beneficial or detrimental, depending on your circumstances. Here are some potential risks you should consider:

Negotiation Problems

The reality is that your creditor might reject the settlement offer. If that happens, you and the debt settlement company may need to make a counteroffer. You might also have to negotiate directly with the creditor to work out a payment plan. In the worst case, you could end up owing more than before, and a rejected settlement offer might push you closer to bankruptcy.

Increased Debt

Fees charged by the debt settlement company or additional fees and interest from your original creditor can significantly increase your overall debt, sometimes by hundreds or even thousands of dollars.

Negative Impact on Credit Score

Creditors are often willing to settle only when they believe it’s their last chance to get paid. This means your accounts may already be overdue or will become overdue as you redirect payments to the debt settlement company. As a result, your credit score could potentially drop by over 100 points and the impact could linger. A settled debt will remain on your credit report for at least seven years.

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Best Debt Settlement Companies

Freedom Debt Relief

Freedom Debt Relief assists with a wide range of unsecured debts, including payday loans and private student loans. However, their services can be costly because, if negotiations are successful, they charge a percentage based on your initial debt rather than the reduced amount. Despite this, the company offers a “program guarantee” that may cap the fees in certain situations.

They provide a free consultation to review your financial situation. While there are no upfront fees, you’ll need to open a savings account with a third party. Unlike many other companies, Freedom Debt Relief is transparent about the associated costs: a one-time setup fee of $9.95 and a monthly charge of $9.95.

Although this is a higher cost for a savings account compared to what banks typically offer for free, it’s not uncommon among top debt relief companies.

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National Debt Relief

If you're overwhelmed with significant debt, National Debt Relief is a reputable company that has been helping clients find financial relief since 2009. They’ve assisted over 600,000 clients in resolving debts up to $100,000 or more.

National Debt Relief offers tailored plans based on your individual needs, with the goal of restoring your financial stability within 24 to 48 months. They specialize in negotiating with creditors to reduce high-interest debt balances. Their service fees range from 15% to 25% of the enrolled debt, and they offer a money-back guarantee.

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Pacific Debt Relief

Pacific Debt Relief charges settlement fees between 15% and 25% of the settled debt, similar to the top-rated debt settlement options, though their overall rating is slightly lower. While their website states that fees are based on total enrolled debt, a company representative clarified that the fees are actually based on the settled debt amount, which could be more affordable.

Pacific Debt Relief has earned a strong reputation, according to online reviews. Nearly 1,500 customers have rated them an average of 4.7 out of 5 stars, and their Better Business Bureau (BBB) rating is even higher, at 4.93 out of 5 stars, based on a similar number of reviews.

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Is Debt Settlement a Good Idea?

The Consumer Financial Protection Bureau (CFPB) warns consumers about the risks of debt settlement. According to the CFPB, working with these companies can be risky, and it’s essential to explore other options as well (which will be discussed later). Consider the following risks before making your decision:

• Credit Impact: If your accounts aren’t already delinquent, they will be once you start diverting payments to a settlement account. Delinquent accounts and debts that are charged off by lenders will remain on your credit report for seven years.
• Accruing Penalties and Interest: When you stop making payments on your debts, you’re likely to incur financial penalties like late fees, and interest may continue to accumulate, increasing the total amount you owe.
• Settlement Fees: Most debt settlement companies charge a percentage of each debt they settle, based on the balance when you enroll in the program. Some charge a percentage of the amount of debt that is eliminated through the settlement.
• Additional Fees: Beyond the settlement fee, you may also be required to pay other fees, such as a setup fee for the dedicated escrow account and a monthly fee to maintain that account.
• Tax Implications: The IRS considers forgiven debt as taxable income. It’s advisable to consult a tax professional to understand any additional tax obligations you might incur when settling your debt.
• Uncertain Outcomes: Debt settlement doesn’t guarantee success. Not all creditors will work with debt settlement companies, and even if they do, they may not accept the settlement offer. The time it takes to settle the debt could cause accumulating fees and interest, potentially offsetting any savings.

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Alternatives to Debt Settlement

If you’re feeling overwhelmed by debt, there are several alternatives to debt settlement that come with less risk, whether you’re considering working with a debt settlement company or trying to negotiate on your own. Here are four options to consider:

Balance Transfer

You can move your debt to a credit card with a 0% APR for an introductory period, sometimes lasting up to 18 months. If you manage to pay off the balance within this period, you can avoid paying any interest on the debt.

Debt Consolidation Loan

A debt consolidation loan allows you to combine multiple debts into a single, more manageable monthly payment, often at a lower interest rate than what you’re currently paying.

Nonprofit Credit Counseling

Meeting with a counselor from a nonprofit credit counseling agency can help you regain control of your finances. A credit counselor can assist with creating a budget, recommend debt consolidation strategies, advise on whether to close some credit card accounts or even provide guidance on bankruptcy.

Debt Management Program

A debt management program (DMP) is another tool offered by nonprofit credit counselors. If you enroll in a DMP, the counselor will work with your creditors to create a repayment plan that consolidates your debts into one monthly payment, often lower than the combined payments you’re making now.

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Frequently Asked Questions

What Percentage of a Debt Is Typically Accepted in a Settlement?

Typically, you can anticipate that a creditor will settle for around 50% of the total debt owed. By accepting a settlement, the creditor acknowledges that receiving a partial payment is preferable to the possibility of getting nothing at all.

How Does Debt Settlement Affect Your Credit?

Debt settlement can lower your credit score by over 100 points, and the impact remains on your credit report for seven years. If creditors close accounts during the settlement process, your credit utilization may rise, further harming your credit score.

Can You Negotiate Debt Settlement Yourself?

Yes, you can handle debt settlement on your own, though it requires a good deal of time and patience. You'll also need to have the cash available to make any agreed-upon payments. Keep in mind that creditors are not obligated to accept a settlement offer.

The Bottom Line

If you’re overwhelmed by debt or facing financial difficulties, debt settlement might offer a way out. However, before choosing this path, make sure you've explored other options and fully understand the pros and cons of handling the settlement yourself versus using a third-party service.

To find the best approach for your situation, carefully assess your financial condition, capabilities, and what you can expect from the process. Also, keep in mind that you can adjust your strategy if your debt settlement efforts aren't going as planned.

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