Debt Settlement: What It is and When It's a Smart Choice

If you’re considering hiring a debt settlement company, here’s what you need to know about how it works and what it could do to your credit.
Last updated Jan. 24, 2023 | By Taylor Medine
Debt Settlement

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If thinking about your credit card balances keeps you up late at night, you’ve probably typed in “how to pay off debt” in the Google search bar at least once or twice. 

While scanning the search results, your eye may have been caught by debt settlement companies offering debt elimination services. But are these companies legit?

The answer is yes, but working with a debt settlement company can still be risky. Although it’s true that debt settlement companies may get rid of your balances for less than what you owe, there’s fine print involved that could have a longstanding impact on your credit.

In this article

2 popular debt settlement companies at-a-glance

Freedom Debt Relief

Freedom Debt Relief

National Debt Relief

National Debt Relief

Minimum debt $7,500 $7,500
Types of debt
  • Credit card debt
  • Medical bills
  • Personal loan debt
  • Department store credit debt
  • Private student loan debt
  • Credit card debt
  • Medical bills
  • Personal loan debt
  • Department store credit debt
  • Private student loan debt
Program length 24-48 months 24-48 months
Fees 15-25% of total enrolled debt 15-25% of total enrolled debt
Availability Approximately 38 states 42 states
Visit Freedom Debt Relief Visit National Debt Relief

What is debt settlement?

Debt settlement is when a creditor agrees to accept less than what you actually owe them in order to settle the account. 

If you’re having trouble repaying debt, your creditor (or the debt collection agency that has taken over the debt) may be willing to take a lesser amount of money to get the debt off their books.

You can negotiate a settlement on your own or hire a debt settlement company to handle it for you. Depending on the agreement, payment of the settlement amount can happen in a lump-sum payment or through an installment payment plan.

Being able to eliminate your debt sounds like a win-win scenario for all parties — you’re no longer on the hook for the full amount of your balance, and the debt collector also gets some money. 

Unfortunately, creditors aren’t always willing to accept a settlement offer, and there are financial risks involved even if the creditor agrees to a settlement plan.

How debt settlement works

If you decide to hire a debt settlement company, the process should start with you receiving disclosures from the company outlining the cost and terms of the service.

  • You set money aside. Typically, you’ll be instructed to put a certain amount of money into a special savings account every month as part of the debt settlement program. This money will be used to make payments to your creditors once an agreement is reached.
  • You stop making payments to your creditors. The debt settlement company may also tell you to stop making payments on your debt during the negotiations. Basically, your non-payment is used as a bargaining tool to convince the creditor to take a debt settlement, but it can take years for this agreement to happen.
  • You begin making payments. If your creditor accepts a settlement offer, you will then begin making payments to satisfy your end of the deal. Accounts typically settle for 33% less than the total debt owed when fees are considered, according to the American Fair Credit Council.

According to the Federal Trade Commission (FTC), debt settlement programs may require you to deposit your money into a savings account for 36 months or more until a settlement is reached. 

Unfortunately, missing payments for such a long period can cause your debt to skyrocket due to late fees and interest charges. It could also damage your credit.

Let's look at an example using a 33% settlement amount. If the total debt on your credit card is $15,000, you could end up paying somewhere around $10,050 with a debt settlement company. 

Once the debt is settled, the account balance will be removed from your credit report, and the account will state that you settled with the credit card company in question.

Should you settle or pay in full?

Paying your total amount of debt in full is better than settling your debt for a number of reasons. The main difference is how each affects your credit score.

If you work with a debt settlement company, any resolved account will be marked as "settled in full" on your credit card. 

While this puts you right with your original creditors, it shows potential lenders that you paid less to your lenders than you originally agreed. This could have a negative impact on your credit score and ability to borrow in the future.

On the other hand, any debt account balances that you completely pay off will be marked "paid in full" on your credit report. This signals to potential future lenders that you have a history of paying off every dollar that you borrow and could help improve your credit score.

Type of debt eligible for settlement

You may not be able to settle every type of debt you have. It’s important to understand the difference between secured vs. unsecured debt.

Unsecured debt is the type of consumer debt that is eligible for debt settlement. Secured loans are already backed by property, such as your car or house. 

That means the lender can repossess and sell that property to recoup its cost, so there’s no incentive for these lenders to negotiate a settlement with you.

Here are examples of debt you may be able to settle using a settlement company:

Drawbacks of debt settlement

While a debt settlement can give you a bit of financial breathing room, it's not always an ideal solution. Here are a few drawbacks of working with a debt relief service.  

  • No guarantees. There’s no guarantee a creditor will negotiate a settlement just because you sign up with a debt settlement company. You could find yourself with months (or years) worth of late fees and interest on your accounts and no settlement to show for it.
  • You could face legal action. Your creditors could decide to file a lawsuit instead of offering you a settlement on your outstanding debt putting you in a legal bind. 
  • May negatively impact your credit. Long-term non-payment can wreak havoc on your credit history, especially if you start the program with decent credit (more on that in a second).
  • It's not free. Working with a debt settlement company also isn’t free. Companies typically charge fees equal to a percentage of the debt that’s settled. These fees come due once a settlement agreement is reached. 
  • You may still owe taxes on your debt. After the settlement, you’re not completely in the clear because Uncle Sam may want a cut of what you didn’t pay. That forgiven debt balance may be considered taxable income, resulting in a debt settlement tax bill.

Benefits of debt settlement

We’ve talked a lot about the disadvantages, but what are the advantages of taking a settlement?

  • Avoid bankruptcy. A settlement may help you avoid bankruptcy. Also, settling debt means you could get creditors off your back and stop all those overwhelming collection calls. Without debt causing you financial stress, you could have more wiggle room to work toward other goals, such as growing your savings account.
  • You can make arrangements yourself. You may be able to negotiate with your lenders yourself, and maybe even arrange your own settlement without defaulting on the debt. This will not only save you fees to a settlement company but this strategy can also help preserve your credit history because you won’t have missed any payments.
  • Better on your credit score than defaulting. Having a debt listed as settled still isn’t great for your credit score, but it may have less of an impact than not paying at all, according to Experian. A debt settlement could do even less damage to your credit if you’re able to convince the creditor to list your account as paid in full instead of settled.

How much does debt settlement affect your credit score?

A settled status listed on your credit history is a negative record that can cause your credit score to take a hit. It can take seven years for the settled account to be removed from your credit history.

On the bright side, getting rid of high credit card account balances can reduce your credit utilization ratio, which could help your score. Your credit utilization ratio is part of the amounts-owed factor of the credit score calculation that accounts for 30% of your FICO Score.

With that said, a lower credit utilization may or may not undo the damage done by missing payments ahead of a settlement. That’s because payment history accounts for 35% of your FICO score calculation. 

The degree to which missed payments will impact your score depends on your individual finances and history. Missed payments do more harm to your score the higher your credit score is, according to data from FICO. 

For instance, someone with a FICO Score of 710 could lose as many as 180 points if a payment is 90 days late. Meanwhile, someone with a FICO Score of 607 might lose 47 points when a payment is 90 days late.

If your credit is already less-than-stellar, the benefits of settling debt could be worth the credit hit because you can work on rebuilding with a clean slate.

How to choose a debt settlement company

Freedom Debt Relief

Freedom Debt Relief

National Debt Relief

National Debt Relief

Minimum debt $7,500 $7,500
Program length 24-48 months 24-48 months
Fees 15-25% of total enrolled debt 15-25% of total enrolled debt
Availability Approximately 38 states 42 states
Visit Freedom Debt Relief Visit National Debt Relief

If you decide to go the settlement route, here’s how to pick the best debt settlement company for you:

  • Compare fees. Shop around with multiple companies to compare prices and terms. Opting for a company that doesn't charge upfront fees is typically a good idea.
  • Look at the company’s track record. Check the Better Business Bureau to review company ratings and search the Consumer Financial Protection Bureau database for complaints. The FTC also recommends checking with your state attorney general’s office to see whether complaints have been filed against the company.
  • Read customer reviews. See what people are saying about the company and its customer service.
  • Ask questions. Call each company and ask about their debt settlement process and find out how long the debt negotiation process typically takes.

How to avoid debt settlement scams

The debt settlement industry is known for scams. Companies may try to take advantage of people’s financial hopelessness and fear, so don’t make a decision in desperation if you’re considering debt settlement.

Most often, the scams involve promises that settlement companies simply cannot guarantee. 

A settlement company can’t guarantee that your creditor will be open to negotiating or guarantee to erase a specific percentage of your balance. Nor can a company state that it can make your debt disappear or stop litigation if you don’t pay your debt.

The FTC also warns against doing business with settlement companies that charge you money before attempting to settle your debt.  

The debt settlement company should disclose the fees, how long the process will take, how much you need to save for the settlement, and the risks involved if you don’t make debt payments.

If a debt settlement company sounds too good to be true, that’s a clear red flag that you could be getting scammed. If you’re the victim of a debt settlement scam, you can file a complaint with your state attorney general’s office.

Alternatives to debt settlement

Signing up for a debt settlement program with a company isn’t something you should do without considering other options first. Here are some alternatives if you're wondering how to pay off debt:

Negotiate yourself

Instead of paying a debt settlement company a fee for the service, you can try to negotiate with creditors on your own. 

If you’re going through financial hardship because of the pandemic, creditors may be willing to establish a payment arrangement so you don’t default. 

Use a debt consolidation loan

If you’re juggling many payments to different creditors, you may be able to consolidate your debt with a debt consolidation loan. This will combine all your debt under one new loan for easier repayment. 

Debt consolidation loans are often installment loans that have a fixed interest rate and fixed repayment term. 

To help you decide which option is right for you, read our debt settlement vs. debt consolidation guide.

Consider a balance transfer credit card

Some credit cards offer new cardholders a 0% APR balance transfer special where you pay no interest on transferred debt during an introductory term. If you are approved, you could have more than a year of interest-free time to pay back your debt. 

For instance, the Citi® Double Cash Card offers a 0% intro APR on balance transfers for 18 months (then 18.24% - 28.24% (variable) APR). 

Check out our list of the best balance transfer cards if you're interested in comparing cards.

Try credit counseling

A nonprofit credit counseling agency may help you with a debt management plan so you can tackle your outstanding balance. 

A credit counselor provides guidance and support for consumer credit, including reviewing your finances and negotiating with your creditors to secure lower interest rates and fees. You just make one payment to the counseling agency which disburses it to your creditors.

Enrolling in this kind of debt repayment plan won’t hurt your credit score, but credit counseling companies do typically charge an upfront fee and monthly fee. 

The cost should be around $50 or less upfront and $25 per month, according to the National Foundation for Credit Counseling. This could work out to be a lot less than you’d pay a debt settlement company and the IRS in taxes owed on settled debt.

Speak with an attorney about bankruptcy

If you’re at a point where you don’t have enough cash to spare to save for a settlement and your debt payments are not manageable, you might consider the bankruptcy pros and cons

A bankruptcy attorney can discuss options with you, including whether you qualify for Chapter 7 bankruptcy vs. Chapter 13 bankruptcy.

FAQs about debt settlement

Is it bad to take a settlement on debt?

No. It’s not bad to settle debt, but it can affect your credit. Having an account listed as settled is a negative record on your credit history that can impact your ability to qualify for future loans.

Sometimes debt settlement companies will tell you to deposit your monthly payment into a separate account instead of paying your creditors. But if you don’t pay your bills, a creditor can file a lawsuit against you. 

If the debt settlement company isn’t able to negotiate your debt, you could end up owing more than you did before working with the company because of late fees and penalty interest.

What percentage of a debt is typically accepted in a settlement?

A study from the American Fair Credit Council shows that debt accounts settle for about 33% less on average than what’s owed when fees are factored in. The amount varies depending on the settlement reached.

How long does it take to improve your credit score after debt settlement?

Negative account records, such as late payments or debt settlements, typically stay on your credit report for up to seven years. However, it can take as little as six months to two years before you see improvements in your credit score after you settle your debt.  

As time goes by, the negative impact of late payments and/or settlements will fade as you build a new, positive credit history by paying your bills on time and reducing your debt.

What is the difference between debt relief and debt settlement?

Debt settlement is a form of debt relief. There are, in fact, a variety of debt relief options. Debt relief is an umbrella term used to describe different services that help people get out of debt. 

An organization that provides debt relief programs may offer credit counseling, debt repayment plans, debt settlement services, and more. Speaking with a debt relief company may help you learn more about all your possible options.

Can I get a credit card after debt settlement?

Your ability to get a credit card after a settlement depends on how poor your credit was prior to the settlement.

Remember that it can take up to 24 months for your credit score to improve once you've settled your debt. Many borrowers may have to wait years before they can get accepted for a credit card.   

Bottom line

Working with a debt settlement company could be an option to consider if you’ve exhausted other repayment solutions. 

Suppose you’re barely staying above water financially, and you can’t qualify for a balance transfer credit card.  Or maybe you’re looking at a debt consolidation loan vs. bankruptcy. In these scenarios, debt settlement services may also be worth exploring.

Consider negotiating your own settlement first. Creditors may prefer to speak with you, and in some cases, creditors may refuse to speak with settlement companies altogether.

Lastly, be sure you understand the risks of hiring a debt settlement company before you do so. If the settlement company can’t reach an agreement with your creditors, you could end up with a much higher unpaid debt balance and in court for the amount you owe.

Debt settlement can be the best option depending on your financial situation, but make sure to fully investigate all your options before you make a big decision about your personal finances.

National Debt Relief Benefits

  • No upfront fees
  • One-on-one evaluation with a debt counseling expert
  • For people with $7,500 in unsecured debts and up

Author Details

Taylor Medine Taylor Medine is a freelance writer who's covered all things personal finance for the last seven years. She enjoys writing financial product reviews and guides on budgeting, saving, repaying debt, and building credit.