What Is Debt Settlement?

Financial difficulties can sneak up on you over time or hit you like a bolt of lightning. One day, you simply can't cover your living expenses and pay your debts, and you didn't even see it coming. But don't blame yourself—it's common to experience money setbacks, and you're doing the right thing by researching solutions. 

One potential solution is debt settlement. Debt settlement, with or without professional help, is a way to restructure some of what you owe to make it more affordable. Successfully settling debt means clearing balances faster and for less money. Then you'll be able to move forward, apply what you've learned during the settlement process and safeguard your financial future.

Let’s take a closer look at exactly what debt settlement is and how it works. 

What Is Debt Settlement?

Debt settlement works by first presenting your case to creditors and attempting to come to an agreement about how much you’ll repay against what you owe. 

The process of debt settlement

A key part of the debt settlement process is debt negotiation, where you or the debt settlement company you work with will attempt to reduce the amount you owe and settle the debt for less. Creditors may be more willing to negotiate with you if they know that you’re having a financial hardship that makes it difficult or impossible to repay the full amount you owe. From their perspective, it’s better to get something than nothing. 

During negotiation, you’ll most likely have to plead your case and explain the financial hardship you’re facing that makes it difficult to repay the loan.

Anyone can try to negotiate their own debts. The process can be time-consuming, stressful, and even overwhelming. You’ll almost certainly have to go through several rounds of communication with each creditor. You’d need to contact each lender, negotiate with them to reduce what you owe, and get a written agreement that outlines the terms of your negotiation. 

Even working with a debt settlement company is not a guarantee that creditors will agree to settle your debt. Some other common pitfalls of debt settlement are a negative impact on your credit score (although you’ll have time to improve it) and the possibility of having to pay taxes on the forgiven debt (if you’re not insolvent when you settle the debt). 

Eligibility for debt settlement

In most cases, those who are eligible for debt settlement are borrowers who can prove they’re really struggling to make debt payments. The types of debts usually eligible for debt settlement are unsecured debts.

Examples include:

• Credit card debt

• Department store charge card debt

• Personal loan debt

• Medical debt

• Some private student loan debt

Secured debts like mortgages and car loans are not eligible for debt settlement. 

If you’re a small-business owner and used personal credit cards for business expenses, debt from those cards could be enrolled in a debt settlement program. But a debt settlement company typically can’t help with business debts.

Can you settle debt on your own?

You can definitely attempt to settle your own debts and may save money by doing so. If you're comfortable when negotiating legal or financial situations, you might be a good candidate for DIY debt settlement. It can also be helpful if you only have one or two accounts to settle because it makes coordinating easier.

When settling debt on your own, you'll act as your own debt settlement consultant and negotiator by taking the following steps:

• Assess your finances. How much do you earn, how much do you owe, and how much can you comfortably afford to pay? How will you come up with this money? What do you need your creditors to do for you? 

• Decide which debt(s) you'll attempt to settle first. For instance, you might target the smallest balance or the account with the highest interest rate.

• Contact your creditors. It can be helpful to write yourself a script to follow when talking to them so you don't forget anything important and so you don't agree to anything you can't afford.

• Negotiate reduced payoffs. Expect to go back and forth, so you'll probably want to start with a lower figure than your maximum to leave room for compromise. Get any agreement in writing before paying anything.

• Make your payment as agreed, whether it's a single sum or a series of payments. Use a secured form like a cashier's check or electronic payment, and get your payment in before the agreed-upon deadline. Keep records of these payments. 

• Make sure that the account has been zeroed and closed and that this has been reported to credit bureaus.

Note that many creditors require accounts to be significantly past-due before they'll negotiate with you. If you encounter difficulties, you can always switch to professional debt settlement, which may be less stressful and get you a better outcome.

Pros and Cons of Debt Settlement

If you’re considering debt settlement, you should be aware of both the pros and cons.

Advantages of debt settlement

May owe less on your debts: Debt settlement works to lower the amount you owe so you could get some relief and not fall further behind on payments.

Could streamline debt payments: One main advantage to debt settlement is the ability to streamline multiple debt payments into one. Instead of paying your creditors individually, a debt settlement company usually sets up a dedicated account where you make a single affordable monthly deposit. 

Costs less than alternatives: Yes, there may be fees associated with working with a debt settlement company. However, you could end up paying less than what you would have owed on your debts without negotiating them. 

Could be a better option than bankruptcy: Debt settlement programs may provide more favorable repayment options compared to bankruptcy filings. Also, debt settlement is private. Bankruptcy is a public record.

Disadvantages and risks of debt settlement

Impact on your credit score: The debt settlement process involves setting aside money for settlement offers. Many people can’t afford to do this and also make their debt payments, so they choose to stop making debt payments (they may already be behind on their bills). Missing payments is almost always harmful to your credit score. But it also demonstrates that you’re struggling financially.

Creditor or collection agency calls: If your debt goes into collections, debt collectors may try to contact you. 

Potential legal action: Some creditors may threaten or actually take legal action to get you to repay your debt. It’s important to know your legal rights as you go through the debt negotiation process. 

If you work with Freedom Debt Relief, if a creditor takes legal action against you for an enrolled debt, we may engage a Legal Partner Network attorney who will attempt to negotiate a settlement. This service is free for qualifying clients who have made their monthly deposits on time. The offer does not apply to legal action taken before you enrolled, or to legal action taken on debts that are not enrolled.

Possible taxes owed: If creditors are willing to lower the amount of debt you pay, that could have tax implications. That means you may have to pay taxes on the amount of debt canceled or forgiven. If you are insolvent when you settle the debt (meaning your debts are worth more than your assets), you may be exempt from federal income taxes on the forgiven debt.

While you could get some financial relief by settling for less than what you owe, knowing the risks is just as crucial. Speaking with a reputable debt settlement company could help you get a deeper understanding of whether the benefits of debt settlement outweigh the risks. 

How to Choose a Reputable Debt Settlement Company

When you evaluate debt settlement companies, it’s important to know how they operate. And as an increasing number of consumers accumulate debt, more debt settlement companies are cropping up to take advantage of the opportunity. Unfortunately, not all have the history and experience to get the best results for clients. 

Red flags to watch out for

It's smart to carefully read anything before you sign and to verify a company's state licensing before you commit. But you may not even get that far if a company gives off "run for your life" vibes. Here are some red flags to look for when choosing a debt settlement company:

Silly language: Sketchy companies might make some wild claims. But your debt won't "disappear like magic." Ditto any claims that a firm can settle your debt for "pennies on the dollar" or any other specific percentage. In fact, creditors are not required to negotiate with you at all, so any provider that "guarantees" that it can settle your accounts at all is breaking the law. You'll also want to avoid companies that advertise nonsense like the "new government program" that's a "secret" or that your creditors "don't want you to know about."

No customer reviews: Most reputable debt resolution companies will have an online presence. If you’re unable to find any reviews for the company, such as from the Better Business Bureau, or speak to anyone who has worked with them, you may want to steer clear.

No clear negotiation process: A good company should be able to explain clearly and exactly how it’ll help you negotiate debts and the ways it’ll keep you informed throughout the process. 

Unclear fees: Some companies may charge a fee upfront or be unclear about the fees they charge. Stay away from any company that charges upfront settlement fees, avoids talking about fees, or won’t detail its fees before you sign a contract. Federal regulations prohibit charging debt settlement fees before you agree to an arrangement and make payment to settle a debt. A reputable company will be very clear about this.

Untrained counselors: You want to be sure the debt counselor you work with is experienced and trained in negotiating with creditors. Consider looking for debt settlement companies that are members of the American Association for Debt Resolution (AADR). This organization enforces a strict code of conduct for its members, and companies can only join if they comply with the industry’s Federal Trade Commission regulations. Not being an AADR member is one sign of a company that may not be reputable.

Key questions to ask before signing up

Before working with a debt settlement company, take the time to speak to each one to assess whether it provides the level of integrity, experience, savings, and customer service you expect and deserve. To choose the debt settlement company that could best help you eliminate your credit card and other debt, ask these key questions:

• How much will the program cost each month?

• What are the program’s negotiation fees?

• How many creditors have you settled debts with?

• How will you keep me informed during the debt negotiation process?

• Where can I read client reviews from real clients?

You can get more information about our program in the Freedom Debt Relief FAQ section. Trust your instincts when evaluating a debt settlement plan. If your gut feeling about a debt settlement company is negative, chances are that company is not the best fit for you.

Common Myths and Misconceptions About Debt Settlement

Don’t fall for these false claims about settling your debts. 

Myth: Debt settlement is an easy way out

Debt settlement isn’t a quick fix, and it won’t be an easy process. It could take longer than you think. Plus, it requires that you make a solid plan and commit to settling debts, which could take time and work. Ditch the idea that debt settlement is a simple or quick fix. It requires commitment and planning. 

Myth: All debts can be settled

You may not be able to settle all of your debts, particularly secured ones like auto loans and mortgages, or debts you owe to the government, like back taxes. If you have unsecured debts you want to settle, you might be able to, but first think carefully whether it’s worth it to go through the effort. 

Steps to Take After Completing a Debt Settlement

Hopefully, settling your debts helps you regain strong financial footing. Clearing at least some of your debts could put you in a better position to manage your finances going forward.

Rebuild your credit

After completing the debt settlement process, your credit score may be much lower than you’d like. Here are some ways you could work on improving your score:

• Check your credit reports and dispute any errors you find.

• Make consistent on-time payments on all your debts.

• Avoid applying for loans or credit cards until you really need to.

• Avoid carrying credit card balances. 

Avoid future debt challenges

Working to ensure you avoid taking on more debt than necessary could prevent you from going back to square one. 

Some strategies to avoid unnecessary debt include building an emergency fund that you could tap into when unexpected expenses arise. Ideally, you’ll set this money aside in a separate bank account for when you need it. This could be easier now that you have experience setting aside money in your dedicated debt settlement account. Set a goal of how much you want to save—it’s OK to start small.

You might also seek additional financial advice, such as learning how to budget with the income you’ve got so that you can better manage expenses. 

Is Debt Settlement Right For You?

Not every debt relief option is right for everyone. 

Who should consider debt settlement?

Debt settlement is not the best debt solution for everyone. It’s for people who can’t afford to fully repay their debts.

Those who aren’t in deep financial trouble usually have less drastic options available—like DIY debt payoff strategies or debt consolidation. 

Consumers with high credit card debt and few assets, and people facing lawsuits may find bankruptcy to be the best choice. Chapter 7 can wipe out your unsecured debts if you qualify, and bankruptcy puts a temporary hold on any debt lawsuits that have been filed. 

Debt settlement requires you to have a strong commitment to getting out of debt, learn how to budget and live within your means, and be comfortable with having your credit score impacted. But it could help many people resolve their debt and get on solid financial ground.

Generally speaking, for those who don’t qualify for Chapter 7 bankruptcy or who own assets they might lose in a bankruptcy, trying to settle the debt yourself or with a professional debt settlement company could be a smart financial move. 

If you’re on the fence, you could contact a bankruptcy attorney or a debt consultant at a debt settlement company who’s trained to answer your questions and help you compare options.

Alternatives to Consider

Some options to consider instead of debt settlement include:

DIY debt payoff: While there's no easy, cheap, or painless way to get debt-free, slow and steady might be right for you if you can afford it. 

Debt consolidation: If you can qualify for one, taking out a debt consolidation loan could help you lower your monthly payments. Debt consolidation replaces multiple payments with one. It can lower your interest rate and/or monthly payment, giving you the breathing room you need.   

Debt management plan (DMP): Nonprofit credit counseling agencies manage these plans that can lower your interest rate and payment. You won’t get any debt forgiveness, but you might receive budgeting help and debt management education if you sign up for a DMP.

Not every option is workable for every consumer. Not everyone qualifies for debt consolidation loans, for instance, because they generally require fairly good credit scores and sufficient income. And credit card debt relief options won't work for people with secured accounts like auto loans. The right option for you depends on your income, types and amounts of debt, and goals.