What is Debt Settlement? Benefits, Drawbacks, and Credit Score Impacts

What Is Debt Settlement

Debt settlement is a process through which you negotiate with creditors to pay less than you owe by offering a lump sum payment that’s lower than your total debt. If they accept, you pay this amount, and they forgive the rest of your debt. 

Debt settlement can hurt your credit score, and it may still take a long time to pay what you owe. In this guide, I’ll help you weigh the pros and cons of debt settlement before deciding whether it’s the right financial option for you.

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How Debt Settlement Works

Debt settlement is a type of debt relief that typically involves a debt settlement service working on your behalf to negotiate with your creditors. They aim to settle your debts for less than what you owe.

First, you contact a debt settlement company to discuss your financial situation. Most companies offer a free consultation, and if they accept you as a client, you will stop directly paying your creditors. 

Instead, you deposit money into an account every month. This account is under your control, but the debt settlement company helps manage it and you use the account to save for eventual settlements.

As your balance grows, the debt settlement professional starts negotiating with your creditors. They explain that you are facing financial hardship and offer a lump sum payment that is less than the total debt. The goal is to convince the creditors that accepting a smaller amount is better than risking getting nothing if you declare bankruptcy. 

Part of this goal is to persuade your creditors not to sue you in court, and negotiations can take time. The debt settlement company will try to reach an agreement with each creditor. 

Source: Federal Reserve Bank of New York

Once a creditor agrees to the lower amount, you authorize the payment from your special account. This process continues until you settle all your debts.

With diligence, you can often settle your debt in 24 to 48 months. This is a practical option if you want to become debt-free in a reasonable amount of time without going through bankruptcy proceedings.

Eligibility for Debt Settlement

Debt settlement is best for people experiencing financial hardship, including job loss, medical bills, or other situations that make it difficult to pay debts. To benefit from debt settlement, you usually need to have a significant amount of debt. 

This often means owing $10,000 or more in total unsecured debt. Debt settlement companies may decline to help you if you owe a smaller amount that is not worth the settlement fees.

Qualifying Debts

Only certain types of unsecured debts qualify for settlement services. These include personal loans, credit card debt, medical bills, private student loans, and collection accounts. 

Typically, debt settlement companies don’t deal with secured debt, i.e., debt backed by collateral such as your home or vehicle. They also typically avoid federal student loans, money owed to utilities, and IRS debts. However, you may find a company that specializes in these types of debt.

Not all settlement companies operate in all 50 states, which may limit your choices depending on where you live.

Assessing Your Financial Situation

Debt settlement is a substantial undertaking. Before taking this action, think about whether your financial circumstances warrant it. Here are some areas to assess when considering your situation:

  • Total Debt Amount: Calculate all qualified debts, including credit cards, personal loans, medical bills, and collections. Ensure the total meets the minimum requirement, usually around $10,000.
  • Monthly Income and Expenses: List all sources of income and all monthly expenses. Subtract expenses from income to find your leftover money each month.
  • Financial Hardship: Identify any financial hardships, such as job loss or high medical bills, that make it difficult to pay your debts.
  • Current Payments: Check how much you pay toward debts each month. Note whether you can make minimum payments or are falling behind.
  • Credit Report: Obtain and review your credit report for current debts and their status. Correct any errors and understand how debt settlement might impact your credit score.
  • Savings Potential: Calculate how much you can save monthly to deposit into a particular account for debt settlement. The more you save, the faster you can settle debts.

Examine these aspects of your financial situation to determine if debt settlement is a suitable option for you. If you still have questions after this assessment, you can contact a debt settlement company that offers a free evaluation and ask questions about your situation.

Benefits and Drawbacks of Debt Settlement

Debt settlement can reduce debt and help you avoid bankruptcy. However, watch out for potential pitfalls, such as credit score damage and a possible tax bill.


  • Reduced Debt: You negotiate partial debt forgiveness. This makes it easier to pay off your remaining debt.
  • Avoidance of Bankruptcy: Debt settlement can keep you out of bankruptcy court. That’s a good thing because bankruptcy is even more damaging to your credit.
  • Faster Debt Resolution: You could settle your debts in 24 to 48 months. This may help you become debt-free much faster than making minimum payments over many years.
  • Stress Reduction: Reducing your debt burden can also relieve financial stress. Knowing you are actively working toward resolving your debt can provide peace of mind.


  • Credit Score Impact: Settling a debt for less than the total amount can lower your credit score. The settlement will remain on your credit report for seven years and it can significantly hamper your ability to get loans or credit in the future. Withholding payments to creditors hurts your credit score and may send your account into collection.
  • No Guarantees: Creditors don’t have to negotiate or accept a settlement offer. There is a risk that some creditors may refuse to settle and instead take you to court.
  • Fees: Professional debt settlement services charge fees, usually a percentage of the settled debt. This will reduce the overall savings from a settlement.
  • Tax Implications: The IRS considers forgiven debt amounts to be taxable income. You may owe taxes on the amount forgiven.
  • Potential for Increased Debt: Interest and late fees may continue to accrue if negotiations take a long time. This can increase your total debt before you reach a settlement.

Decide whether debt settlement makes sense for your financial situation by weighing these benefits and drawbacks carefully.

Getting Professional Help With Debt Settlement 

Debt settlement companies have teams of professionals who negotiate settlements every day. These professionals often have connections with various creditors, making it easier to get better results. 

Companies offer a range of services and specialists also know strategies that can help achieve the best outcomes for their clients.

Services Provided

Debt settlement companies can help you in several ways. These are the typical services you can expect from them:

  • Financial Assessment: They examine your financial situation to determine whether debt settlement is a viable option for you. If so, they create a plan to save money in a special account to repay part of your debt.
  • Negotiation: Settlement companies talk to your creditors to get them to forgive some of the money you owe.
  • Settlement: They urge creditors to accept money from your settlement account.
  • Support and Guidance: They provide ongoing support and advice, helping you manage your account and stay on track.

Debt settlement companies may also offer credit counseling and consolidation services.

Choosing the Right Company

Start by reading up on companies with good reviews from past clients. Check complaints on the Better Business Bureau (BBB) and Trustpilot websites and search for relevant user reviews on forums such as Reddit and myFICO.

Check online reviews from trusted sources, including BadCredit.org. The Consumer Financial Protection Bureau (CFPB) and the Federal Trade Commission (FTC) websites offer guides on how to recognize honest debt relief organizations. Select a company accredited by reputable organizations such as the American Association for Debt Resolution (AADR) or the International Association of Professional Debt Arbitrators (IAPDA).

Ensure the company is transparent about its fees and the services it provides, and avoid companies that make unrealistic promises or guarantees. You want to work with a proven service that has plenty of experience in debt settlement. 

debt settlement sources graphic

Ask about their success rate and how long they have been in business, and keep an eye out for red flags. These include asking for upfront payment, promising to improve your credit score, charging high monthly fees, charging a high percentage based on the reduced debt amount, and guaranteeing that your debt will go away or that your credit report will improve.

A debt relief service is not a bank. It will request that you put money into an escrow account to cover the payments it negotiates. Insist the funds go into an FDIC-insured bank account.

Typical Fees and Timelines

You must pay for professional debt settlement services with a debt consultant. Most companies charge between 15% and 25% of your enrolled debt (the total debt you include in a debt settlement program). Understand that a debt settlement company can only collect payment from you once it has settled your debt, you’ve agreed to the settlement, and you’ve made at least one payment to the creditor.

The debt settlement process can take up to four years. The timeline depends on your debt obligations and how quickly you can save money for settlements. Regularly depositing funds into your special account can help accelerate the process.

Only commit to a debt settlement program once the company has explained how it will charge you for its services. This information should be in your agreement. 

You don’t have to sign if you don’t agree with it or think it’s too expensive. Instead, you can look for other, more affordable debt relief solutions.

Impact on Your Credit Score

Working with debt settlement companies can lead to severe credit damage in the short and long term. Most of the damage they cause remains on your credit reports for seven years. As bad as that seems, remember that bankruptcies stay for up to 10 years.

Short-Term Effects

Your payment history will suffer because missing even one debt payment can negatively impact your score.

On a debt settlement plan, you may miss payments for years. Creditors report missed payments once they are 30 days late and continue to report them as the late period increases.

payment history graphic
Payment history is worth 35% of your FICO credit score points.

In addition, your credit utilization ratio (i.e., credit used-to-credit available ratio) increases as your debt balances grow due to late fees and penalty interest charges on unpaid debt. A CUR above 30% harms your credit score.

Long-Term Consequences

The long-term credit score consequences of settled accounts are serious. When you settle a debt, your credit report shows you paid less than the total amount owed. This can lower your credit score for several years.

Lenders see settled accounts as a sign of financial trouble, making it harder for you to get new credit or loans. You may face higher interest rates and less favorable terms. The settled account will stay on your credit report for up to seven years, impacting your creditworthiness and access to financing.

Strategies to Recover from Credit Score Damage

Legally, no one can make a credit bureau remove a settlement from your credit report if it is accurate. Nonetheless, you can take action to improve your credit report:

  • Focus on Positive Credit Behavior: Make on-time payments, pay down debt, and keep low credit card balances. 
  • Dispute Errors: Check your credit reports frequently and dispute any errors hurting your score. The credit bureaus have 30 days to fix any inaccurate information.
  • Goodwill Letter: You can write a goodwill letter to the creditor, asking it to remove the settled account from your credit report. You never know — they might agree if you have a good payment history since the settlement. But beware: The credit bureaus may say no. 
  • Wait For it To Drop Off: Settled accounts stay on your credit report for seven years. After this period, the bureaus will automatically remove them.

These are some of the ways to reduce the damage of a settled account on your credit report.

Alternatives to Debt Settlement

Debt settlement and bankruptcy are the nuclear options for handling debt. You may prefer a more conventional approach that does little or no damage to your credit scores. However, these safer alternatives won’t reduce the amount of money you owe.

Debt Consolidation

Debt consolidation can be an effective solution when you are overwhelmed by debt. It replaces your current loans and credit balances with one monthly payment. In this way, you avoid multiple accounts and due dates. 

You’ll usually pay a lower interest rate and know your fees in advance. Debt consolidation can work through consolidation loans or balance transfer credit cards.

Consolidation Loan

A debt consolidation loan is often an unsecured personal loan. It allows you to pay off your existing loans and credit balances, leaving you with just one monthly payment. 

This is a DIY method because you pay off your existing debt — not the lender. It requires more personal involvement than debt settlement. It can also significantly improve your credit score by lowering your credit utilization ratio.

credit utilization ratio graphic
Credit utilization ratios over 30% can harm a consumer’s credit score.

When using a consolidation loan to pay off credit card balances, do not reuse the cards before you repay the loan. A good strategy is to stow your credit cards away and only use your debit card for purchases and bill payments. After repaying the loan, you can retrieve your credit cards and use them again, hopefully wisely.

Balance Transfers 

You can use the balance transfer method to consolidate credit card debt. You start by obtaining a balance transfer credit card with a 0% introductory APR for six to 21 months and a credit line large enough to cover your existing credit card debt.  You transfer each card balance (fees apply) to the new card and try to pay it off before the introductory offer ends.

Balance transfers require fair to excellent credit, but they can save you hundreds (or thousands) of dollars in interest and boost your credit score over time. Again, lock your credit card away until you’ve paid off the consolidated balance. The biggest risk with debt consolidation is a need for more discipline.

A lack of self-control can lead to new debts before you repay the existing debt. Taking on new debt defeats the purpose of consolidation. You’ll make multiple payments again and could find yourself in deeper trouble than when you started.

Credit Counseling

Credit counseling provides financial education and helps you manage your debt. A credit counseling agency can assist with debt relief. These agencies design affordable monthly payment plans for you. 

They may offer a debt management plan if you have a lot of credit card debt. Certified credit counselors review your financial situation and create a budget to start the process. They offer advice on managing your money and debts and help you develop a plan to tackle your monetary issues.

credit counseling graphic

With a debt management plan, you could secure lower interest rates with your creditors and become debt-free more quickly. They usually arrange payment plans to relieve your debt in three to six years. You send monthly payments to the counseling company, which distributes the funds to your creditors until your debt is fully repaid. 

If you pursue credit counseling, choose a reputable company with a solid track record and good reviews on the BBB website. The company should be a member of an organization such as the National Foundation for Credit Counseling or the Financial Counseling Association of America.

Consider credit counseling if you owe at least $5,000 in unsecured debt, such as credit card or personal loan debt. A certified credit counselor can be a great resource to help you with your debt.


Consider bankruptcy only as a last resort when dealing with overwhelming debt. Although it can provide a fresh start, it has long-term consequences for your credit and financial future. There are two main types of bankruptcy for individuals: Chapter 7 and Chapter 13.

Chapter 7 bankruptcy involves liquidating your non-exempt assets to pay off your debts, and it can provide a fresh start by discharging most unsecured debts within a few months. Chapter 13 bankruptcy allows you to keep your assets and repay your debts through a court-approved plan over three to five years, making it a good option if you have a steady income.

Both Chapter 7 and Chapter 13 bankruptcy go through the courts. In Chapter 7, the court oversees the liquidation of non-exempt assets to pay off debts. In Chapter 13, the court approves and monitors your repayment plan.

Let’s compare the two types of individual bankruptcy to debt settlement:

EligibilitySignificant unsecured debt, financial hardshipMeans test (income below a certain level)Stable income, unsecured and secured debts
ProcessNegotiate with creditors to pay less than what is owedLiquidation of non-exempt assets to pay debtRepayment plan over 3 to 5 years
Duration24 to 48 months3 to 6 months3 to 5 years
Credit ImpactAdverse impact remains on a credit report for 7 yearsSevere impact remains on a credit report for 10 yearsSevere impact remains on a credit report for 7 years
Debt DischargePartially discharged (settled amount)Most unsecured debts are dischargedUnsecured debts discharged after repayment
Fees and Costs15% to 25% of settled debt amountCourt fees, attorney feesCourt fees, attorney fees
Asset ProtectionAssets are not directly affectedNon-exempt assets may be soldKeep assets but must adhere to a repayment plan
Tax ImplicationsForgiven debt may be taxableDischarged debt is not taxableDischarged debt is not taxable
RepaymentMonthly payments to a particular accountNo repayment, other than liquidated assets, requiredMonthly payments to the trustee
CollectionsCollection efforts paused during the negotiationAutomatic stay stops collectionsAutomatic stay stops collections

Prudence dictates that you seek the advice of a legal and/or financial professional before pursuing any of these options. All of them will harm your credit, but you can repair the damage over time through creditworthy behavior.

Settlement Can Be a Costly Way to Overcome Your Debt

Debt settlement is an expensive way to manage debt due to fees, impact on your credit scores, and potential tax implications. Better alternatives include credit counseling, through which a certified counselor can help you create a budget and manage your debts, and debt consolidation, which combines your debts into one payment with a lower interest rate.

If these options don’t work, Chapter 7 or Chapter 13 bankruptcy may provide relief, though they have severe consequences for your credit. Always explore all options and seek professional advice before deciding.