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. 

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What Is Debt Settlement?

Debt settlement, also called 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.

In order to show financial hardship, you have to stop paying your creditor (goodbye excellent credit score; hello pesky collections calls). 

Rather than pay your creditors, you will pay into an account with your debt relief company. Once the company says you have enough money for the payoff, they will make the negotiation call with one creditor. 

How Much Does Debt Settlement Cost?

Many companies can negotiate the debt down 30% to 50% less than you owe, but they will also pay themselves a fee, typically between 15% and 25% of the settled debt. 

Here’s how it might look at the end:

• You owe $10,000 on credit card A.
• Debt company settles the account for $5,000 and charges $1,250 in fees (assuming a 25% service fee). 
• You still pay $6,250 for your debt and also have major work to do on your credit score. 

In this scenario, you will save $3,750, but what if the company could only settle your debt for 30% and then charges 25% in fees? Suddenly your savings look a lot smaller. 

Plus, the IRS is not going to look the other way for this transaction. You will need to pay taxes on the forgiven amount — i.e., the $5,000 forgiven debt. 

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 up to 50% of debt
• Can have more time to pay off debt on your timeline 
• If you are already in collections, this can put an end to the harassment calls
• 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:

• Not all debts can be settled, such as mortgages and student loan debt
• 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
• Can take up to 48 months to resolve debt
• You will owe taxes on forgiven debt 
• Increase in harassment calls while you stop paying (to prove financial hardship) and threat of legal action

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 lower, about $25 to $40 for the set-up fee and $5 to $20 for the monthly fee — though fees are capped and determined by the state you live in. 

While this is not a free option for getting out of debt, it is a better alternative to debt relief since it does not hurt your credit score. 

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, many hospitals offer financial assistance programs for uninsured patients. 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.

The catch is that credit card hardship programs are temporary. You’ll still owe the money — and maybe even more to make up for the interest accrued during the program.

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

Can I do debt settlement by myself?

Yes, you can pursue debt settlement on your own without the assistance of a debt relief company, but the process will still look the same. 

You will need to establish financial hardship and have a lump sum ready for when you call to do the negotiations. 

Keep in mind that creditors can be hard to deal with and are not required to accept a payoff. 

Are debt relief companies safe? 

Legitimate debt relief companies are not scams, but they might cost you more in fees than you are prepared to pay for your debt. 

To avoid scam debt relief companies, look for businesses that have transparent fee structures and do not charge anything until your debt is settled. Additionally, you should read reviews from trusted websites and never feel pressured into signing up. 

Is there a government debt relief program?

No, there is not a government-sponsored debt relief program for personal debts, and if anyone advertises or promises such a thing, be sure to run in the other direction. 

That said, some government programs can help you manage your student loan, mortgage, or tax debt — usually through payment plans. 

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 you have to stop paying your bills to prove financial hardship, 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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