Is Debt Settlement Worth It?

Is Debt Settlement Worth It?
Key Takeaways:
  • Debt settlement has potential costs as well as benefits.
  • You can decide whether the benefits are worth it based on several factors.
  • Knowing what to look for can help you make a good decision about debt settlement.

Debt settlement could drastically reduce the amount of money you owe, bringing great relief to a tough situation. But it’s not a quick or easy way to get out of debt. After you balance out the costs and benefits, is debt settlement worth it?

The answer depends on your circumstances. Debt settlement can be worthwhile if your situation fits, and if you understand the risks.

Debt settlement is an option for unsecured debt

Debt settlement is for unsecured debt—for instance, credit card balances and personal loans.

Secured debt, like mortgages and car loans, isn’t a candidate for debt settlement. After all, debt settlement depends on negotiating with creditors to have them accept less than the full amount owed. If there is collateral on the loan and you default, they’ll take possession of the collateral (that’s what it’s for). It’s common for people to have a mix of secured and unsecured debt. Debt settlement can still work in that case. You simply separate the two types of debt and use debt settlement for the unsecured debts.

Once the unsecured debts are settled, it could be easier to afford the payments on your secured debts. 

Debt settlement works best if you are insolvent

Being insolvent means the amount of your debt exceeds the value of your assets. Believe it or not, insolvency has a silver lining: It can wipe out a potential tax liability from canceled debt.

Under most circumstances, the IRS treats canceled debt as income and you’d generally have to pay taxes on the amount that was forgiven. Those taxes would reduce the financial benefit of debt settlement.

If you’re insolvent, though, canceled debt is not taxed. The IRS has a worksheet to help you figure out your situation. Check out IRS Publication 4681 for the worksheet and more information on insolvency. 

Debt settlement may be right if your credit is already damaged

People often warn that going through a debt settlement process can affect your credit. In many cases though, for people considering debt settlement, the damage is already done. 

Late payments are hard on your credit score. If you owe a lot of money and have already been missing payments, your credit score might not have much farther to fall.

Once you settle one or more debts, you can focus on managing your other bills and paying on time every month. Debt settlement could be the first step to 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 of settling debts without incurring a tax liability. In Chapter 7, a court decides how to use your assets to settle your debts. If you don’t have much in the way of assets, this can be a cost-effective way of settling debts.

However, if you aren’t low income, you may not qualify for Chapter 7. The courts say that if you have the means to pay your bills, you’ll have to file for Chapter 13 bankruptcy instead, which is a 3-5 year payment plan. 

Also, like late payments, bankruptcy has a negative impact on your credit record.

In short, you should consider Chapter 7 bankruptcy as an alternative to debt settlement. If you don’t qualify for Chapter 7 based on your income, or if you don’t want a bankruptcy on your record, you may decide debt settlement is a better option.

Professional negotiators could relieve some of your burden

If you work with a debt settlement firm, they will do the heavy lifting. They’ll help you organize your debts, they’ll make the calls to your creditors, they’ll negotiate the settlement, and they’ll handle the transfer of your money to the creditor, ensuring the creditor stands by what they agreed to. If you’re not comfortable with the idea of negotiating, which can be a difficult multi-call process, you can hand that task off. Debt settlement companies may already have relationships with some or all of your creditors, and might be able to negotiate a better deal than you could get for yourself.

You’ll probably pay a fee for their services. So this becomes a cost-benefit decision: Would you eliminate more debt than the amount of fees you’d owe? 

Keep in mind that you should never pay a fee until you get results. By law, debt settlement firms may not charge a fee until they negotiate a settlement, you approve it, and at least one payment has been made. Then they can charge their fee.  

The right debt settlement firm is a key to success

A big factor in whether debt settlement is worth it is having the right professional to guide you through the process.

Some things to look for when choosing a debt settlement firm:

  • Have they been in business for several years?

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

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

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

Understand the costs of debt settlement

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

  • Possible late fees and interest charges. During the debt settlement process, you may choose to stop paying your creditors so that you can save up funds to make settlement offers. This could cause the amount you owe to rise. 

  • Potential damage if your credit is currently fair to good. If you have decent credit at the start, it’s likely to take a hit as you go through a debt settlement process. 

  • Fees may reduce the debt settlement benefit. Consider whether the amount of debt reduced is worth the fee a debt settlement firm would charge. 

  • Settled debts may mean you have to pay taxes unless you’re insolvent. Be sure you understand your tax situation before accepting a debt settlement solution. It’s best to talk to a qualified tax professional.

Recognizing these potential costs puts you in a stronger position to make an informed decision about debt settlement. Once you know how it works, you can be more confident that debt settlement will be the right choice for your situation.

Debt relief by the numbers

We looked at a sample of data from Freedom Debt Relief of people seeking debt relief during June 2024. This data reveals the diversity of individuals seeking help and provides insights into some of their key characteristics.

Credit card balances by age group for those seeking debt relief

How do credit card balances vary across different age groups? In June 2024, people seeking debt relief showed the following trends in their open credit card tradelines and average credit card balances:

  • Ages 18-25: Average balance of $7,378 with a monthly payment of $209

  • Ages 26-35: Average balance of $10,797 with a monthly payment of $300

  • Ages 36-50: Average balance of $14,340 with a monthly payment of $405

  • Ages 51-65: Average balance of $14,364 with a monthly payment of $420

  • Ages 65+: Average balance of $14,837 with a monthly payment of $397

These figures show that credit card debt can affect anyone, regardless of age. Whether you're just starting out or nearing retirement, managing credit card debt can be challenging.

Manage Your Finances Better

Understanding your debt situation is crucial. It could be high credit use, many tradelines, or a low FICO score. The right debt relief can help you manage your money. Begin your journey to financial stability by taking the first step.

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