Is Debt Settlement Worth It?

Debt settlement could significantly reduce the unsecured debt you owe, and offer real relief when you face a tough financial situation. The process takes time and effort, and each step forward brings you closer to relief.

If you’re comparing the costs and benefits, you have already started the process. Whether debt settlement is worth it depends on how those costs and benefits impact your situation.

Debt Settlement Pros and Cons at a Glance

Before you decide, review the core trade-offs of debt settlement:

Potential pros

• Reduce the total amount of unsecured debt you owe

• Help you avoid bankruptcy

• Stop collection calls on a debt once it's settled

• One point of contact if you work with a professional negotiator

Potential cons

• Credit damage, especially if your credit is currently fair or good

• No guarantee that creditors will accept a settlement offer

• Professional debt settlement companies charge a fee, typically 15% to 25% of the enrolled debt

• Forgiven debt is generally taxable unless you're insolvent

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How to Know If You're Ready for Debt Relief

You are the one who decides if you're ready to try debt relief. Answer a few questions to assess your debt situation:

• Have I fallen behind on debt payments?

• Am I in a cycle of taking on new debt to cover old debt?

• Am I turning to credit to pay for necessities?

• Are my credit card balances increasing despite my best efforts to pay them down?

• Is my debt causing me anxiety or sleepless nights?

If you answered “yes” to a few of these, debt relief solutions are at least worth a look. You could approach this in a few different ways, depending on the size and type of debt you have. And how comfortable you are managing financial situations.

A DIY solution could work if your unsecured balances aren’t that high, or if you only have one account to deal with. A professional debt relief company could be right if the idea of contacting creditors on your own raises your stress level. These companies work with you to negotiate your debts and resolve them for less than what you owe. Many debt settlement companies already have relationships with major creditors, which could give them an advantage during negotiations.

If you think professional debt settlement might be a good fit for you, act promptly. Reach out to a company like Freedom Debt Relief to learn more about how its program works and whether your debts are good candidates for settlement.

Debt Settlement Is an Option for Unsecured Debt

Debt settlement is for unsecured debt, such as credit card balances, medical debt, and personal loans. Unsecured debt isn't backed by collateral—something of value that the lender could seize if you fail to repay the debt.

Secured debt, like mortgages and car loans, isn't eligible for debt settlement, since the lender could simply repossess the collateral and sell it to recover their money. It's common for people to have a mix of secured and unsecured debt. In that case, you separate the two types of debt and use debt settlement for the unsecured debts, which could make it easier to afford the payments on your secured debts.

Debt Settlement Works Best if You Are Insolvent

In most cases, the IRS treats canceled debt as income, and those taxes would reduce the financial benefit of debt settlement. 

If you're insolvent, though, you won't owe taxes on at least some of your canceled debt. Being insolvent means the amount of your debt exceeds the current fair market value of your assets. If your debts (before debt settlement) total $20,000, and your assets are worth $15,000, you are insolvent by $5,000. That means you get up to $5,000 of debt forgiveness tax-free.  IRS Publication 4681 has a worksheet to help you calculate your debt forgiveness tax. It's also a good idea to talk to a tax professional.

Creditors generally must report forgiven debt of $600 or more to the IRS on Form 1099-C, and you should expect a tax bill if you're not insolvent.

Debt Settlement May Be Right if Your Credit Is Already Damaged

Debt settlement could affect your credit. For many people considering debt settlement, the credit score damage is already done. If you owe a lot of money and have missed payments, your credit score might not have much farther to fall.

On the other hand, settling one or more debts may help you afford your remaining bills and pay them on time. Debt settlement could be the first step toward a stronger credit profile and a better financial future.

Debt Settlement Is an Option if You Don't Qualify for Chapter 7

Chapter 7 bankruptcy is a way to get rid of eligible debts without racking up a tax liability. With Chapter 7, a bankruptcy court takes your non-exempt assets, which are things you own that are not protected from bankruptcy, to repay your creditors. For example, if you have several cars, the bankruptcy court could force you to surrender all but one to the court, which sells the assets and manages payouts to your creditors. If you, like most Chapter 7 filers, have few or no assets up for grabs, Chapter 7 could be a cost-effective way to eliminate debt.

Generally, your income must be at or below the median in your state for your household size to qualify for Chapter 7. This threshold exists to force those who can afford to pay at least some of what they owe to file Chapter 13 bankruptcy instead. Chapter 13 is a three- or five-year plan in which the court decides how much you must pay each month. If you successfully make all of your plan payments, any remaining balance is forgiven.

Bankruptcy has a negative impact on your credit. If you don't qualify for Chapter 7, or if you don't want a bankruptcy on your record, you may decide debt settlement is a better option than Chapter 13.

Professional Negotiators Could Relieve Some of Your Burden

If you work with a debt settlement firm, professional debt negotiators will do the heavy lifting. A trustworthy debt settlement company has trained experts who:

• Help you organize your debts

• Make the calls to your creditors

• Negotiate the settlement

• Handle the transfer of your money to creditors

• Ensure creditors honor their side of the agreement

If you're not comfortable with the idea of negotiating, you could hand that task off entirely. Debt settlement companies may already have relationships with some or all of your creditors and might negotiate a better deal than you could get on your own. You'll probably pay a fee for their services, so whether debt settlement is worth it becomes a cost-benefit decision: compare the debt you would eliminate against the fees you would owe.

By law, debt settlement firms are not permitted to charge a settlement fee until they negotiate a settlement, you approve it, and you make at least one payment.

The Right Debt Settlement Firm Is a Key to Success

The right professional could make a big difference in whether debt settlement is worth it. Consider a few questions when choosing a debt settlement firm:

• How long have they been in business?

• Do they have a successful track record with a large number of clients?

• Is their explanation of the process and cost clear and sensible?

• Are they transparent about the debt settlement industry laws that they must follow?

Understand the Costs of Debt Settlement

Debt settlement could wipe out a portion of your debt. You decide if that reward is worthwhile once you've considered the costs.

Fees and interest charges

During debt settlement, you might choose to stop paying your creditors while you save up funds for settlement offers in a dedicated bank account. These payments may be less than the minimum payments on all your debts that you were paying previously. Stopping payments could lead to late fees, credit damage, and collection efforts, including possible lawsuits.

Potential damage if your credit is currently good or better

If you have decent credit at the start, it's likely to take a major hit as you go through a debt settlement process. This may not be a concern for you if your credit is already fair or poor because of a history of late payments. 

Fees may reduce the debt settlement benefit

If you work with a professional debt settlement firm, you'll pay a fee for its help—typically, 15% to 25% of the enrolled debt. Here's an example of how that could work for a settled amount:

Potential Cost of Debt Settlement

It's not possible to know ahead of time the exact savings you'll get because creditors don't have to accept any settlement offers. If working with a debt settlement company reduces your stress and saves you some legwork, that’s a bonus that may add value to the fee..

Settled debts could be taxed

Be sure you understand your tax situation before accepting a debt settlement solution. It's best to talk to a qualified tax professional.

A debt settlement program could take at least two to four years to complete depending on how much you owe and how quickly you're able to save for a settlement offer. You may need to work with a tax professional each year to determine how an offer could affect your tax liability.

If anything is unclear, get a solid  explanation from the debt settlement company before you move forward. Most offer a free consultation so you can  ask questions and understand how the process works.

Warning Signs of Debt Relief Scams

Most debt settlement companies that have been around a few years are legitimate and reputable. Still, you'll need to watch out for scammers who want your hard-earned cash. Scammers often:

• Demand upfront payment

• Make guarantees about settlement offers (“pennies on the dollar!”)

• Promise to stop all collection calls and lawsuits

• Refuse to provide or are evasive about their business details

• Pressure you to hand over personal or financial information

• Pressure you to stop contact with your creditors

If you encounter any of these red flags, don't give the company any personal information. Report it to the Federal Trade Commission (FTC) right away.

Then, choose a legitimate debt relief company instead—one that:

• Doesn't take payment until it's negotiated a settlement offer, you've agreed to it, and at least one payment has been made toward the agreement

• Has been in the business for at least several years

• Is transparent about how it operates and how it gets paid

• Is a member of an organization like the American Association for Debt Resolution (AADR) or the International Association of Professional Debt Arbitrators (IAPDA)

Conduct some online research about any company you’re considering, including customer reviews and how long it's been in business, before handing over your information. The Consumer Financial Protection Bureau also offers guidance on evaluating debt relief options and avoiding scams.

Alternatives to Debt Settlement

If you don't think professional debt settlement is worth it for you, other options are available to help resolve your debt.

Hardship programs

Some creditors offer hardship programs for people facing temporary financial setbacks. They may not advertise this. If you call or write to the company and explain your situation, you may be offered lower payments, a lower interest rate, or deferred payments for a while.

This works best for a short-term setback rather than a long-term debt problem.

DIY debt settlement

You could negotiate your debts directly with your creditors instead of paying a company to do it for you. This approach could help you minimize fees. It does take time, and it requires you to budget for repayment on your own each month.

Credit counseling

Credit counseling agencies are nonprofit organizations that work with your creditors to lower your interest rates where possible and set up a debt management plan (DMP). You make one monthly payment to the agency, which pays your creditors on your behalf, and you will probably be required to close your enrolled credit card accounts.  DMP payments tend to be higher than settlement payments since they're designed to fully repay your debt in three to five years.

Debt consolidation loan

A debt consolidation loan, often a personal loan, is a new loan you take out to pay off existing debts. It usually has a fixed interest rate that may be lower than what you’re currently paying on your credit cards. You trade multiple payments for one, and the amount might be lower than your combined credit card minimum payments. If the interest rate you’re offered isn’t below what you’re currently paying, this option may not help you.

Cash-out refinance or home equity loan

Homeowners with sufficient equity could try a home equity loan, home equity line of credit, or cash-out refinance. That means taking out a second mortgage on your home to clear your credit card balances or replacing your existing mortgage with a new, larger one and using the difference to repay your existing debts. You'll go through the usual steps that come with a mortgage, including an appraisal and closing costs, so weigh those before you proceed.

Bankruptcy

A bankruptcy filing is a formal request to a bankruptcy court for protection from creditors. Bankruptcy is an alternative to debt settlement for those who want to eliminate some or all of their debt through the court system. It's wise to weigh the pros and cons of bankruptcy to figure out if it's the best course for your situation.

Bankruptcy has two main types: Chapter 7 and Chapter 13. Chapter 7 could resolve your debts within a few months if you meet the income requirements. You may have to give up some assets. Chapter 13 requires you to make monthly payments for three to five years into a court-ordered repayment plan, and you may not save money over the long haul.

The judge's decisions are binding in a bankruptcy, and creditors are not able to opt out.

Build Your Financial Future After Debt Settlement

When you finish debt settlement, you reach an exciting milestone. That’s a great time to work for a stronger financial future. Once your debt is resolved, build a new budget and start an emergency fund in a savings account you are able to access quickly. The goal is enough to cover three to six months of living expenses, but it’s okay to start small. Even a few hundred dollars can get you out of trouble when the unexpected happens.

You’ll also want to start rebuilding your credit. Make on-time payments, avoid carrying credit card balances by spending less than you earn. Apply for new credit sparingly. If you manage debt well, your credit score could rise over time, making it easier to borrow money more affordably.