Is Debt Settlement a Good Idea? 

If you have hundreds — or even thousands — of dollars in debt, it can feel like you are never going to escape it. 

Cue the many companies claiming to make all your debt problems disappear with a wave of their magic wand. 

While some of these debt relief companies are legitimate businesses, it is important to understand how debt settlement works and how it will affect your overall financial health. 

What Is Debt Settlement?

Debt settlement — one flavor of what companies market as “debt relief” — is when you negotiate to settle your debt for less than you owe.

The problem is that you can’t just call up your creditor and say, “I know I owe $7,500, but I have $4,000 in cash I can give you today to settle the account.” 

Instead, debt settlement companies negotiate on your behalf, and only after you have proven your financial hardship and inability to pay the full amount.

To build leverage — and to build up the cash for a lump-sum offer — these programs tell you to stop paying your creditor (goodbye excellent credit score; hello pesky collections calls). It's not a rule your creditor imposes; it's how the strategy works, and it's where most of the damage comes from.

That takes a while. CFPB data show the first settlement typically lands four to five months after you enroll, with the average successful settlement coming about 14 months in — all of it while your accounts sit unpaid.

How Much Does Debt Settlement Cost?

Companies advertise settlements of 30% to 50% off what you owe — though no honest company can promise you a number — and they'll also pay themselves a fee. By law, that fee is calculated one of two ways: a share of the total debt you enrolled in the program, or a percentage of what they saved you. Which one you're signed up for changes the math a lot, so ask before you enroll.

Here’s how it might look at the end:

• You owe $10,000 on credit card A.
• The company settles for $5,000 and charges 25% of the $5,000 it saved you — $1,250.
• You still pay $6,250, and you have major work to do on your credit score.

That's a $3,750 savings. But if your fee is 25% of the $10,000 you enrolled instead, you owe $2,500 in fees — $7,500 all in, and your savings shrink to $2,500.

Plus, the IRS may not look the other way. Forgiven debt generally counts as taxable income — in this case, the $5,000 that got wiped out — and your creditor will send you a Form 1099-C for anything they write off of $600 or more. There's a big exception, though: if your debts outweighed your assets when the debt was settled — the IRS calls this being insolvent — you may be able to exclude some or all of it using Form 982. Debt wiped out in bankruptcy is excluded too. It's worth a conversation with a tax pro before you assume you owe.

READ MORE: How To Pay Off Credit Card Debt

Is Debt Settlement Worth It?

Debt settlement can seem like a savior, especially if you owe a lot of money and think the fees are worth it. But if you are hoping debt relief will be your get-out-of-jail-free card, think again. 

Pros of debt settlement companies

If you feel like bankruptcy is the only option to help you solve your financial crisis, then debt settlement is admittedly a better choice. 

Here are the perks of pursuing debt relief:

• Can settle accounts for less than you owe
• Can have more time to pay off debt on your timeline 
• Once an account is actually settled, the collection calls on that account stop
• Can help avoid bankruptcy or foreclosure

Cons of debt settlement companies

If you aren’t on the brink of financial ruin and can afford to pay your debt, that is the better move. 

Here are some of the disadvantages of debt relief:

• Secured debts like your mortgage or car loan generally aren't settled — the lender can just take the property instead
• Federal student loans have their own compromise process through the Department of Education, not a settlement company
• No guarantee that creditors will accept a settlement — in other words, you are still on the hook for your debt and fees/penalties on top of it
• Hefty debt settlement fees
• Major hit to your credit score
• Often takes three years or more — and many people don't last long enough to get everything settled
• You may owe taxes on forgiven debt
• Collection calls tend to ramp up while you're not paying, and creditors can sue

If you do decide that debt relief is the best option for your situation, check out these Best Debt Relief Services. Make sure that any company you go with is upfront about their fees and the process.

Overwhelmed By Debt? Do This Instead 

Debt doesn’t have to keep your life in a chokehold. Pursuing debt settlement should be your second-to-last option, just before bankruptcy. There are other solutions to try first.

Put your budget into emergency mode

I know the word “budget” may not strike excitement in your heart and, in this case, I’m talking about activating the strictest level of budgeting. 

Emergency mode budgeting is when you cut everything non-essential and pay the minimum possible for essential expenses. 

It is a good strategy to practice when you face a layoff or financial emergency, need to double down on debt, or want to expedite your savings goal. 

Ideally, you should only live in emergency mode for three to four months, since it can be wearisome and happiness-draining. Look at your current budget for what you can easily cut and throw those funds at debt. 

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Explore better loan options

Moving your debt over to a debt consolidation loan or a limited-time 0% APR credit card can help you make faster progress since you’ll pay less toward interest. 

Plus, having all of your debt on one loan or credit card can help you keep track of how much you owe in total. It also makes it easier to make extra payments throughout the month. 

However, getting these loans or transferring credit card balances can come with hidden fees — so do your homework before deciding. 

READ MORE: How to Do a Balance Transfer the Smart Way

Consider credit counseling

Many non-profit credit counseling agencies offer free sessions that allow you to analyze your debt and create an actionable plan. 

While the first consultation is free, expect a push to enroll in a debt management plan (DMP), which comes with a set-up fee and a monthly maintenance fee. 

These fees are generally modest — Money Management International, one of the largest nonprofit agencies, publishes an average $38 setup fee and $35 a month — though fees are capped and determined by the state you live in.

While this isn't a free way out of debt, it beats debt settlement on credit: enrolling doesn't tank your score the way settlement does. You may see a dip when your cards get closed, but MMI reports its clients average an 82-point improvement by the time they finish the plan.

Negotiate on your own

While it’s not easy, it is possible to negotiate with your creditors on your own rather than going through a debt settlement company.

For example, every nonprofit hospital is required to have a written financial assistance policy — ask for it by name, and know that you don't have to be uninsured to qualify. And some credit card issuers offer hardship programs that grant you a temporarily reduced interest rate or reduced monthly payments.

To qualify, you need to contact your credit card company directly and provide proof that you’re experiencing financial hardship — such as you’ve lost your job or are going through a medical crisis.

If collection calls are the problem, you don't need a settlement company to stop them — send the collector a written request to stop contacting you, and under federal law they have to. Just know that silencing the calls doesn't erase the debt; they can still sue you and still report it.

READ MORE: How to Negotiate Medical Bills, Step-by-Step

Increase your income

If you are stuck in the debt cycle, you might need to increase your income to better afford your necessities. 

While asking for a raise at work is a good place to start, in some cases starting a side hustle or finding a way to earn passive income might be easier. 

You don’t need to start a huge business in your free time, but you can offer services you excel at for extra cash. Think hair cutting, house cleaning, child/pet care, gardening, baking, and more. 

Not sure if you have any skills? You can also sell your unwanted items and use the cash to pay down debt. A clean closet and one step closer to being debt-free: that’s a win-win. 

READ MORE: How to Negotiate Salary According to Business and HR Pros

FAQs

TL;DR: How Safe Is Debt Settlement?

Debt settlement is a gamble — while debt relief companies can help reduce your debt, they also charge hefty fees and there’s no guarantee that a creditor will accept the negotiations. 

And since these programs tell you to stop paying your bills, you're putting your credit score at risk.

Try all other debt management methods first, and only consider debt settlement as a last stop before bankruptcy.

For more tips on how to manage your money and become debt-free, check out these episodes of the Erika Taught Me podcast:

• Get Past Your Money Mistakes
• How To Budget For Beginners
• 10 Steps Towards Financial Wholeness

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