How to Avoid 8 Common Debt Settlement Pitfalls: Risks to Know Before You Enroll

Carrying more debt than you can manage isn't easy. So it’s good that you’re researching options and taking control. Debt settlement is one option that could help you reset your finances and build a stronger future. Before you enroll, understand the risks of debt settlement, including credit score damage, fees, and no guarantee that a creditor will agree to settle. And like any long-term strategy, it comes with costs and takes patience.

Here are the ins and outs, fees, and potential problems of debt relief. Understanding the downsides as well as the benefits should help you decide if debt relief makes sense for you.

What Is Debt Settlement?

Debt settlement is a debt relief strategy in which you negotiate with your creditors to get them to accept less than you owe as payment in full. Creditors are often willing to do this if they believe that you can’t afford to repay the entire balance, and that partial repayment is the most they can expect. 

It's possible to negotiate with creditors entirely on your own. You usually need a lump sum to offer a creditor in exchange for forgiving the remaining balance. You might do this by skipping payments and putting that money into savings.  Other options include borrowing against a 401(k) or tapping existing savings. Next, you’d contact  your creditors to make an offer. 

Once a creditor has agreed to settle the debt, the debt settlement company passes the offer along to you. You choose whether to accept or reject it. If you accept it, payment will be sent from your designated account to your creditor. When the creditor receives the full agreed-upon amount, it forgives the rest. (Many settlements involve a single one-time payment, and others involve a series of payments.) Most people enrolled in debt settlement programs reach their first settlement agreement within a few months.

Then, the cycle continues with new creditors until you've paid off or successfully settled all your enrolled debts. Though creditors may choose not to settle, many will, especially if there's been protracted negotiation or they fear you may declare bankruptcy, which could prevent them from getting any money from you in the future.

Many people prefer working with a professional debt relief company. That way, experts do the negotiating on their behalf. All you have to do is put money into a designated account and approve settlement offers as they come in.

Debt settlement companies aren't allowed to collect any payment until they reach an agreement with your creditor, you approve it, and authorize at least one payment to the creditor. Then, the pros may collect their debt settlement fee.

Debt settlement typically takes between two and four years to complete, depending on how much enrolled debt you have and how quickly you can save. So it's important to understand exactly what you're getting into and the potential challenges you may encounter along the way before you begin.

Here are eight common debt settlement pitfalls, and how to avoid them.

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Debt Settlement Pitfall #1: Thinking Debt Settlement Is a Big Magic Wand

Solution: Focus on the right debt.

One of the biggest debt settlement pitfalls is assuming it applies to all your debt at once. This isn't always the case.

Debt settlement works with unsecured debt like credit cards, personal loans, or medical bills. These debts aren't backed by collateral—something the creditor could take and sell if you fall behind on payments.

On the other hand, secured debts like mortgages and car loans are not a good fit for debt settlement. That's because the home, car or other collateral has value. So if you don't pay, the creditor may seize it and sell it. Collateral is a safety net for the lender.

With unsecured debt, creditors don't have this option to get their money back.

If your primary goal is to deal with your unsecured debts and leave only your secured debts to manage, debt settlement could work for you.

Debt Settlement Pitfall #2: Not Considering Debt Settlement Alternatives

Solution: Weigh other options first.

One of the most costly debt settlement pitfalls you may encounter is diving in without exploring your other choices. Just because debt settlement is a potential solution to your problems doesn't mean it's the only one. Or the best one.

Before you decide on any strategy, consider all the ways you might get a handle on your debt.

Debt consolidation loans

You take out a debt consolidation loan (often a personal loan) and use it to pay off multiple other debts. Personal loans don't require collateral and typically have lower interest rates than credit cards. But not everyone qualifies for lower rates. For someone with poor credit, debt consolidation loans may not be a practical option because of the cost.

If you're able to get a debt consolidation loan, you'll have a predictable monthly payment. Don't run up new debt on your credit cards or you could wind up worse off than you were before.

Debt management plan

Credit counselors set up a debt management plan (DMP) to wrap your unsecured debts into one monthly payment. They also negotiate with your creditors for lower interest rates or to get rid of certain fees. As with debt settlement, the results vary depending on how much the creditor is willing to bend.

You put money into a special account every month, and the counselor distributes it among your creditors. The payments can be high because the plan is designed to fully repay your enrolled accounts within three to five years. If you've been making minimum payments, your monthly cost could increase. But if you have a good income and need some professional guidance, you could be a good fit for a DMP. You may connect with a credit counseling agency directly to find out whether a DMP is a fit.

DIY debt payoff plan

The debt snowball and avalanche methods are two ways to pay off debt across multiple credit cards. In either strategy, you'll pay the minimum on all of your cards each month. Then, you put any extra you have toward the card with the lowest balance (snowball method) or the highest interest rate (avalanche method). When that card is paid off, you move onto the next card in line until all balances are zeroed.

Balance transfer card

A balance transfer credit card lets you move your credit card balances to another card—ideally one with a 0% introductory rate. The introductory period typically runs six to 21 months. There's usually a one-time balance transfer fee, typically ranging from 3% to 5%.

Balance transfers could make it easier to pay down what you owe since you don't have to worry about your debt swelling due to daily interest charges. But you'll have to choose a credit card issuer you don't already owe. Creditors you already work with have no incentive to offer you a 0% interest rate. Because of the relatively short time at the introductory rate, balance transfers aren't a good debt consolidation option for many people.

Debt Settlement Pitfall #3: Underestimating How Long Debt Settlement Takes

Solution: Get ready for the long haul.

A debt settlement program typically takes two to four years to complete. How long it takes you depends on how much you owe, how much you're able to save, and how many payments you’ve missed.

During debt settlement, you'll save up money to offer your creditors in an account that you own and control. It's hard to afford this while also making your debt payments. So many people choose to stop paying their unsecured debts while they're in a debt settlement program. 

Your creditors will probably reach out to you during this time. They might call you or send you letters alerting you to the amount you owe, hand your debt to a collection agency, or even sue you for the debt. You might also get hit with late fees, and interest may keep adding to your balance while you save for a settlement offer.

Charge-offs and collection actions during settlement

Expect creditors to take action to try to recover their money when you begin working toward debt settlement. If you stop making payments, your creditor may charge off your account. It writes off the outstanding debt as a loss and leaves a note on your credit report. That’s just an internal process for taxes; you still owe the money. 

A charge-off can stay on your credit report for seven years from the original delinquency date or the date of the first missed payment, though its effect will diminish over time.

Creditors sometimes sell this old debt to debt buyers, or hire collection agencies, which may pursue you for the money. They may contact you or send you notices in the mail requesting payment. In some cases, debt collectors may take legal action against you. It’s more likely if the amount owed justifies the expense of going to court and the collector believes it can collect a judgment.  If a court rules against you, your wages or bank account could be garnished.

If you'd like to avoid legal action, be careful about asking debt collectors to stop contacting you. They're legally required to stop if you ask. If they have no other way to get in touch with you, they may be more likely to file a lawsuit.

Debt Settlement Pitfall #4: Negative Impact on Your Credit Standing

Solution: Build financial stability first. Better credit may follow.

If you stop paying your debts, your credit score is likely to suffer. It’s a common debt relief strategy because creditors are often unwilling to negotiate with you if you're current on all of your payments.  And many borrowers find it difficult to pay their creditors while saving up for a settlement offer. .

Your payment history is the single most important factor in your credit score calculation, accounting for 35% of your FICO Score. Even a single late payment could drop a credit score by over a hundred points, depending on how late the payment was and how good your credit was to start with.

You might not be concerned if some of your accounts are already in delinquency. If your debts are in collections or default, your credit score is probably low. If you currently have good credit, you might be reluctant to let it go.

Even if a company does agree to your settlement offer, the debt will probably appear as "settled" rather than "paid as agreed" on your credit report. A settled debt is better for your credit standing than a delinquent debt, but not as good as “paid as agreed.”

If you choose to go ahead with debt settlement, stay focused on your main goal: becoming financially secure.

If your debts make it impossible to keep up with your monthly bills or save for your long-term goals, a hit to your credit might be the lesser of two evils. Once you've gotten rid of those debts, you're able to refocus on improving your credit and building emergency savings.

Negative marks like late payments can stay on your credit report up to seven years, and their effect also declines over time. So while a late payment six months ago might be really hard on your score, a six-year-old late payment won't be. If you avoid carrying balances going forward and make consistent on-time payments, your credit score should begin to rise.

Debt Settlement Pitfall #5: Going It Alone When You're Stressed

Solution: Get professional guidance.

It's possible to negotiate directly with your own creditors. If you have the grit and patience, go for it.

Creditors want to get paid, so they usually play hardball if you tell them you're unable to pay your debts. If you're uncomfortable negotiating on your own, overwhelmed by the process or don't think you can get the best outcome, you don't have to go it alone.

Working with a professional debt settlement company might make the process easier and more successful. You won’t have to  contact every single one of your creditors, likely multiple times, to make offers and negotiate terms.

Debt Settlement Pitfall #6: Falling for a Debt Relief Scam

Solution: Choose professional debt settlement help carefully.

Trustworthy debt settlement companies are there to do the negotiating work for you. But scams claiming to settle your debts quickly and easily are common too.

Before choosing a debt settlement company, research it carefully to make sure you're dealing with a reputable organization. Signs of a legitimate company include:

• Long, established history in the business

• Successful track record

• Trained experts

• Membership in an industry association, such as the American Association for Debt Resolution

• Doesn't charge fees unless a settlement is reached, you approve it, and at least one payment is made to the creditor

• Doesn't promise to wipe out a specific amount of debt (there's no guarantee)

• Doesn't claim to prevent debt collection calls and lawsuits (they aren't able to)

• Doesn’t claim access to "government programs" to wipe out consumer debt (there’s no such thing)

If you come across a company that tries to charge upfront fees, promises to wipe out all your debts, or says it will eliminate your debts in just weeks, it's likely you're dealing with a scam. Don't give it any information. Instead, get the facts about debt settlement from a reputable company like Freedom Debt Relief.

Cost and fee structures in legitimate debt settlement

Debt settlement companies are legally prohibited from charging you an upfront debt settlement fee. The only fee you might pay when initially enrolling is a setup fee for your dedicated account. And you might have an ongoing account management fee, about $10 per month, which goes directly to the financial institution hosting the account. Not to the debt settlement company.

In order for a debt settlement company to receive payment, it must do the following:

• Make an offer to your creditor that that creditor accepts.

• Get your approval of the settlement offer.

• Make at least one payment on your behalf to the creditor.

Only then is the debt settlement company permitted to collect its payment. At Freedom Debt Relief, the debt settlement fee is 15% to 25% of the enrolled balance. This money comes directly out of your designated account, so you won't receive a bill.

Suppose you owe a creditor $10,000, and your  debt settlement company negotiates a $5,000 settlement offer. You agree and your creditor is paid from your account. Then, the debt settlement company earns its 25% fee, which would be $2,500 for this debt. That’s a total of $7,500 to clear a $10,000 balance. 

Debt Settlement Pitfall #7: Underestimating the Tax Consequences of Debt Settlement

Solution: Consider your tax situation before you settle a debt.

Be prepared for the potential tax consequences of debt settlement. The federal government considers forgiven debts, including debts you eliminated through debt settlement, to be taxable income. The IRS generally requires creditors to report forgiven debt of $600 or more on Form 1099-C.

If you owe $10,000 to a creditor who then agrees to accept $4,000, the other $6,000 could be taxable in the year the creditor forgives the debt. If you're in the 22% tax bracket, you'd owe $1,320 in taxes on that amount of forgiven debt.

However, you may not have to pay any tax on the forgiven debt, depending on your circumstances.

If you're insolvent—that is, the total value of what you owe is bigger than the total value of what you own before you settle any debts—some or all of the forgiven debt is tax-free. 

This government freebie depends on how insolvent you are. If the current fair market value of your assets is $45,000, and your debts (before settlement) total $50,000, you’re insolvent by $5,000. That means you’re eligible for $5,000 of tax-free debt forgiveness. If you settle a $10,000 balance for $4,000, that’s $6,000 of debt forgiveness. You’d owe taxes on $1,000. 

You can determine your insolvency by completing the IRS Insolvency Determination Worksheet. Consult with a tax professional before settling any debts to be sure you understand how the process could affect you.

Debt Settlement Pitfall #8: Feeling Hopeless and Lost

Solution: Have a debt expert describe the plan, your options, and what to expect.

Explain your situation to a debt expert. They'll let you know your options and what will be expected of you. This should include how they will negotiate with your creditors and what fees you might pay.

Dealing with debt isn't quick or easy, and your debt settlement professional should be there to support you through the entire process. Like your own private cheerleader. If they're not, find a new one.

Lean on your debt expert and negotiators. Their job is to help people going through a rough time. They've helped others just like you.

Legal risks and creditor lawsuits during settlement

Your debt expert should also be there to support you through any potential legal risks that could arise. Enrolling in a debt settlement program doesn't stop lenders from attempting to sue you for the outstanding balance. But suing someone costs time and money, and there’s no guarantee that they’ll win or be able to collect on a judgment.

If a creditor tells you it’s pursuing legal action against you, don't ignore it. If you don't show up in your own defense, the judge could rule in the creditor or debt collector’s favor by default. Then, the court may give the creditor permission to garnish your bank account or seize your assets. In that case, it may be less interested in your settlement offers.

You don't have to go it alone. Freedom Debt Relief partners with the Legal Partner Network, a network of attorneys who specialize in debt negotiation. These attorneys may step in and attempt to negotiate a settlement offer on your behalf before the court proceedings go further.

There's no charge for this service as long as you're making your scheduled payments to your dedicated account. This benefit only applies to debts already enrolled in the program before the lawsuit was filed.

Using Debt Settlement to Get Your Finances Back on Track

Are there debt settlement pitfalls to watch for? Yes. But knowing what they are may help you avoid them.

Using debt settlement successfully might be the turning point that eventually puts your financial problems behind you.