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.
- What is debt settlement?
- How debt settlement works
- Drawbacks of debt settlement
- Benefits of debt settlement
- How much does debt settlement affect your credit score?
- How to choose a debt settlement company
- 2 popular debt settlement companies at-a-glance
- How to avoid debt settlement scams
- Alternatives to debt settlement
- FAQs about debt settlement
- Bottom line
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. But 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.
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.
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.
The Federal Trade Commission states that debt settlement programs may require you to deposit your payment money into that savings account for 36 months or more before a settlement can be reached. Missing payments for such a long period can cause your debt balance to skyrocket because of late fees and penalty interest charges. Plus, it can damage your credit.
If your creditor accepts a settlement offer, you will then make the necessary payments to satisfy your end of the deal. Accounts typically settle for 33% less than the total amount of debt owed when fees are considered, according to a report published by the American Fair Credit Council, an association that represents the debt settlement industry.
For example, if the total debt on your credit card is $15,000, you could end up paying somewhere around $10,050 by using the services of 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.
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
There’s no guarantee a creditor will negotiate a settlement just because you sign up for a program with a debt settlement company. That means you could find yourself in a position with months (or years) worth of late fees and interest on your accounts and no settlement to show for it. Even worse, a creditor could decide to file a lawsuit instead of offering you a settlement, and this could put you in a legal bind. Furthermore, 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).
Working with a debt settlement company also isn’t free — the fee is typically a percentage of the debt that’s settled and comes due once a settlement agreement is reached. After the settlement, you’re not completely in the clear either because Uncle Sam may want a cut of the amount you didn’t have to pay. That forgiven debt balance may be considered taxable income, so you could get hit with a debt settlement tax bill.
Benefits of debt settlement
We’ve talked a lot about the disadvantages, what are the advantages of taking a settlement?
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 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.
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 do positive things to 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. Someone with a FICO Score of 710 could lose as much 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
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 negotiation typically takes.
2 popular debt settlement companies at-a-glance
Freedom Debt Relief
National Debt Relief
|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|
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. A company cannot truthfully state that it can make your debt disappear or stop litigation if you don’t pay your debt.
The FTC warns to avoid doing business with settlement companies that charge you money before attempting to settle your debt. Also, be sure to read the fine print. 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:
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. Some credit card companies are helping people in this way.
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. You can also check out our list of the best balance transfer credit 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. As part of this plan, a credit counselor reviews your finances and negotiates with your creditors to secure lower interest rates and fees. Then you make one payment to the counseling agency and it disburses payments 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 a late payment or debt settlement, typically stay on your credit report for up to seven years. As time goes by, the negative impact of late payments and/or settlement will fade as you build 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.
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 seriously 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 decision.