When Is Debt Settlement the Best Option

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Key takeaways

Debt settlement is when a creditor accepts a lump-sum payment in exchange for forgiving the remainder of your debts.
You can settle your debts on your own or hire a debt settlement company.
Settling debts comes with risks. It is best suited for people who owe a significant amount and cannot afford monthly payments.

Americans are living in debt. The Federal Reserve Bank of New York found that household debt grew to $17.94 trillion in Q3 2024, with credit card debt at a record high of $1.17 trillion.

If you’re one of the millions of Americans carrying debt from month to month, you may wonder, ‘Is debt settlement worth it’? It may be!

Settlement is when your lender accepts a payment that is less than you owe and forgives the remaining balance. It will get you out of debt for less but don’t take it lightly. Debt settlement will damage your credit score and come with fees.

Read on to find out if settlement is the right choice for you and what other debt relief strategies you could employ.

What is debt settlement?

Debt settlement is a form of debt relief. It is when you or a third party negotiates with your creditors to pay off your outstanding balance for less than you owe. It can be for as much as 50% less than due.

Settlement only works with unsecured debts. These include credit card balances, medical bills, personal loans, and collection accounts. The process will not work for secured debts like mortgages or auto loans. It also will not apply to student loans or taxes owed.

Remember that most creditors will only settle if you’re severely behind in payments. When your accounts are delinquent, settlement may be the only way a creditor believes they’ll be paid.

You also need to be able to afford a lump-sum payment. This typically requires saving up for.

Who should consider debt settlement?

Consider settlement if you’re facing overwhelming debt.

The monthly minimum payments are unaffordable. You may already be late.

You have no hope of repaying the money within five years.

Your outstanding debt equals half or more of your gross income (before taxes).

You can save up for a lump sum payment.

You don’t qualify for a debt consolidation loan due to poor credit or want to avoid bankruptcy.

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How can you settle debts?

The first thing you need to do is assess your financial situation. Start by writing down everything you owe, income, and monthly expenses. Figure out how much you can afford to pay each month. Debt settlement is most effective when you’re unable to keep up with your minimum payments.

Enroll in a debt settlement program or DIY settlement

You can negotiate debt. Your credit card company or lender may be willing to negotiate a settlement, recommend a payment plan, or enlist you in a hardship plan. Be realistic about how much you can afford to pay.

If you don’t want to negotiate yourself, you can hire a company to do it on your behalf. They have the resources and expertise to help you with the process. You do have to pay a fee. On average, debt settlement companies charge 15% to 25% of the enrolled debt for their services.

Stop making payments (if advised)

The company you hired may advise you to stop payments to creditors. Instead, you make payments into a savings account they manage.

Be aware that missing payments lead to late fees, a penalty APR (annual percentage rate), and a drop in your credit score. Since you’re in a debt settlement program, you are likely already behind on payments, and your score has already suffered.

Negotiate with creditors

When you have enough funds, it’s time to negotiate. Either you or your agent will reach out to your creditors with an offer. Creditors may agree to settle if they believe it’s the best way to recover some money.

Always request a written agreement stating the settlement terms, including that the remaining balance will be forgiven. A written settlement agreement protects you from future disputes.

Then, make a single payment to your creditor and your account is considered resolved.

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How to compare debt settlement companies

If you decide to work with a third-party, choose carefully. The best debt settlement companies will be accredited, have a successful track record, and have good reviews on consumer advocacy websites.

Accreditation and certification

The company you work with should be accredited by either the American Fair Credit Council (AFCC) or the International Association of Professional Debt Arbitrators (IAPDA). Certification indicates that the company adheres to industry standards and ethical practices.

Transparency and disclosure

A credible debt settlement company will be clear and transparent about its fees, services, and the debt relief process. It should not guarantee results, make specific promises, or ask for fees upfront.

Legal compliance

A reputable company will comply with federal and state regulations regarding debt settlement and be licensed to operate in your state. Look for companies that uphold the Federal Trade Commission (FTC) rules that prohibit upfront fees and require honest advertising. Legal compliance is a strong indicator of a company’s legitimacy and reliability.

Fee structure

Companies are only allowed to collect fees after successfully negotiating a settlement. The performance fee is a percentage of the original debt. Some companies may also charge a monthly fee to manage the bank account where you deposit funds. The company may charge a late payment fee if you miss a payment. Compare fees to understand the actual cost of their services.

Communication and support

Quality customer service is essential. The best companies will assign you a dedicated account manager who will answer your questions and inform you about your account’s status.

Eligibility

Ensure that you qualify and that your creditors will work with a debt relief company. Your creditors may prefer you to negotiate independently or work with a credit counselor. Many debt settlement companies require you to have at least $10,000 in unsecured debts. Some require $20,000 to be eligible.

Debt settlement scams to watch out for

The debt industry is rife with charlatans looking to take your money. Make sure that you only engage legit debt relief programs.

Here are a few red flags to watch out for.

– Upfront fees: It is illegal to ask for payment before a successful settlement. Never pay a fee upfront, and walk away from any company that requests one.

– Guarantees for specific results: Debt settlement is inherently risky. No company can guarantee results.

– Lack of transparency: Legitimate firms will clearly break down their plans and fees. Avoid companies that aren’t forthcoming with this information.

– Pressure tactics: Scammers often use high-pressure sales techniques to rush decisions. Take your time and consult independent financial advisors or credit counselors before proceeding. A legitimate company will wait for you.

– Advertised as a government program: Some impostors claim to be affiliated with government programs. Verify their legitimacy by cross-checking with official government resources.

– Told to stop communicating with your creditors: Keep an open line of communication with your creditors throughout the process. Preventing you from getting information is a sign of a scam artist.

– Assures you they can stop a lawsuit from a collection agency: Unlike bankruptcy, settlement does not protect you from lawsuits or stop debt collection calls.

Is debt settlement worth it?

The answer is different for everyone. Take a look at your finances, decide what you want, and how comfortable you are with the risks.

Consider these questions:

Do you have significant unsecured debts you cannot realistically pay off in five years?
Do you need help affording the minimum payments?
Have you considered other debt relief options like consolidation, credit counseling, and bankruptcy?
Are you okay with the negative effect on your credit score?
Can you save up for the lump-sum payment, fees, and potential taxes?

If you answer yes to most or all of these questions, settlement might be a worthwhile option.

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Debt settlement risks

Settlement can be one of the cheapest ways to become debt-free, but it comes with risks.

Credit score will suffer: It may drop by 100 points or more. The drastic score drop is mainly due to missed payments.

Negative mark: Debt settlement is a negative mark on your credit report that will stay there for up to seven years from the first missed payment. Additionally, your account will be reported as “settled for less than the full amount” or “charged off.” Future lenders will not look kindly on this.

Debt will grow: When you stop making minimum payments. Your creditor will charge late fees, and interest will continue to accrue. The whole process can take years. Unless you can settle all your accounts, you may not save money due to the fees and interest charges.

No guarantees it will work: Your creditors may not agree to settle for less. Certain financial institutions refuse to work with debt relief companies.

Fees and costs: Companies charge fees for their services. That’s money that goes into their pockets.

Owe income taxes: The IRS considers any forgiven debts over $600 taxable income. If you prove you are insolvent, you won’t have to pay these taxes. Speak with a tax professional first.

All that said, the immediate relief from settlements might outweigh the negative consequences.

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Alternative debt relief options to consider

Debt settlement is the right choice for some people, but not everyone. Before you decide what route to take, explore all your debt relief options.

Debt consolidation

Debt consolidation involves combining multiple debts into one with a lower interest rate. It simplifies the repayment process – one creditor and one monthly payment. Plus, you save money on interest.

You can choose between a debt consolidation loan or a balance transfer credit card.

Personal loans almost always have lower interest rates than credit cards. This can be the way to go if you can qualify for a loan with a low interest rate and few fees.

Balance transfer credit cards can be an effective way to save money on interest. Most come with an introductory 0% or low APR for the first 12 to 21 months. Pay off your debt during this time frame, and you won’t pay a dime in interest.

You will need good to excellent credit to qualify for a balance transfer. Balance transfers often come with fees of 3% to 5% of the transferred amount. Do the math and make sure the interest savings are worth the costs.

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Credit counseling

Nonprofit credit counseling agencies offer financial education, budgeting assistance, and debt management plans (DMPs). Look for agencies accredited by the National Foundation for Credit Counseling (NFCC).

A DMP can help you pay off creditors in three to five years. The credit counselor negotiates a reduced interest rate or waived fees to make monthly payments more manageable. You pay the agency, which distributes the funds among your creditors. Agencies often have agreements with financial institutions to help participants.

A DMP is similar to consolidation, but you don’t need good credit to qualify. You must close credit card accounts as part of the plan and pay a monthly fee. The fee may be reduced or waived depending on your income.

Bankruptcy

Bankruptcy is a legal process that can wipe out unsecured debts. You can either file for Chapter 7 or Chapter 13 bankruptcy.

Chapter 7, or liquidation bankruptcy, erases most debts in three to four months if you qualify. You must pass the means test. The test compares your average monthly income over the past six months to the median income for a household of your size in your state. If your income is below the median, you qualify. If it is above, you must assess your disposable income to see if you can repay some of what you owe.

In Chapter 13 bankruptcy, you will pay off your outstanding balances over three to five years using a court-approved repayment plan. Once you complete the plan, any remaining unsecured debts will be discharged.

Bankruptcy will do a number on your credit. Chapter 7 stays on your report for up to ten years and Chapter 13 for seven years from the filing date.

While your credit score will tank, bankruptcy is not without its advantages. It is a legal process, so you are more likely to get your debts discharged, you are protected from lawsuits, and it offers a fresh start. Talk to a bankruptcy attorney before you go this route.

Frequently asked questions

1. How much can you save with debt settlement?

You can save 20% to 50% of your total debt, depending on negotiations. Success depends on your financial situation and the creditor’s willingness to negotiate. Remember, that amount does not include any fees or taxes due.

2. How can you find legit debt relief programs?

Look for companies accredited by organizations like the American Fair Credit Council (AFCC) or the International Association of Professional Debt Arbitrators (IAPDA). Read reviews on sites like the Better Business Bureau (BBB) and Consumer Affairs for complaints or red flags. A legit company will not demand payment upfront or make unrealistic promises.

3. Is it worth settling credit card debt?

It can be worth it if you’re overwhelmed and can’t pay your credit card bills. Settlement can reduce what you owe, but it will hurt your credit and come with fees. Assess your situation and consider credit counseling first.

4. What is a debt settlement scam?

It is when an individual or company falsely promises to help you reduce or eliminate your debt. Scammers often demand upfront fees and utilize high-pressure tactics to get you to agree without thinking. In the end, you are left worse off financially.

5. How can you repair your credit after settlement?

Pay your bills on time and in full every month. Aim to reduce your credit utilization ratio to below 30%. Apply for secured credit cards or credit builder loans. You can also utilize rent reporting services to give your score an additional boost. It will take time, but anyone can build credit.

Bottom line

When you’re struggling under a mountain of bills and see no way out, settlement can offer the relief you need. It can be the cheapest way to get out of debt quickly, but it comes at a cost.

To decide whether debt settlement is worth it, look at your finances and credit score. If your credit score is already suffering from missed payments and you see no other way out, this can be the right choice. Settling debts can give you a fresh start without having to declare bankruptcy.

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Rachel Alulis

Rachel Alulis has been the lead editor for Moneyfor’s credit cards team since 2015 and for the financial rewards team since 2023. Before joining Moneyfor, Rachel worked at USA Today and the Des Moines Register. She then established a successful freelance writing and editing business specializing in personal finance. Rachel holds a bachelor’s degree in journalism and an MBA.

When Is Debt Settlement the Best Option

Key takeaways

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What is debt settlement?