The Guide to Debt Settlement

Debt settlement can help reduce your total debt size and can’t afford your regular monthly payment. It’s possible to pay off your existing balance with less money with the help of a debt relief company.

While this debt payoff strategy can forgive some of your debt without declaring personal bankruptcy, it’s not risk-free. This guide can help you learn how to safely settle debts along with the potential risks and scams.

How debt settlement works

Debt settlement occurs when the lender or a debt collection agency agrees to accept a smaller payment and forgive the remaining balance as you can’t pay the entire balance within a reasonable period.

Receiving a smaller lump sum can be more convenient and cheaper than pursuing legal action or insisting on full repayment.

Usually, debt settlement is only available after at least 90 days of missed payments when the account becomes delinquent. However, it can require up to four years of non-payments before you can settle certain debts.

Debt settlement is also known as debt negotiation or debt arbitration.

Below is an overview of what debt settlement looks like:

  1. Hire a settlement firm: Most people use a state-licensed settlement company or law firm to help navigate this process to avoid mistakes and scams.
  2. Stop making debt payments: Your hired firm will most likely instruct you to no longer send monthly payments to the lender or collection agency. Unfortunately, this action displays as non-payments on your credit report and can hurt your credit score.
  3. Make escrow payments: Instead of reducing your debt balance, the debt settlement company collects monthly payments and places them in an escrow account (minus service fees).
  4. Request debt settlement: After the company believes you have a sufficient balance, they will contact the creditor and request a lump-sum accommodation.
  5. Pay off debt: The creditor sends a settlement offer stating the final amount due. If you accept the payoff terms, you’re potentially debt-free if you have no remaining loans or revolving accounts.
  6. Pay debt forgiveness taxes: Current tax law makes forgiven debts above $600 subject to income taxes. After a successful debt negotiation, you must also pay the debt settlement company their service fees.

According to the American Fair Credit Council, the average debt settlement plan savings is 30% before fees. Debts may settle in increments and most companies initiate the first settlement within 4-6 months.

Types of Debts Eligible for Settlement

Most personal, unsecured debt without collateral can be eligible for debt settlement.

Eligible debt types can include:

  • Credit cards
  • Department store charge cards
  • Personal loans
  • Medical debt
  • Select private student loans

More importantly, this debt must be at least 90 days delinquent. This is because the original lender may still be collecting payments. Charged-off debt at least 180 days delinquent that a third-party debt collection agency holds can also qualify.

These debts won’t qualify for debt settlement:

  • Home mortgages
  • Auto loans
  • Federal student loans
  • Overdue taxes
  • Lawsuits
  • Unpaid utility bills

Can I Settle Debt for Less than I Owe?

Yes, the lender can settle for less than the existing balance. However, creditors aren’t required to agree to a settlement even if you hire a debt settlement company.

You can request a settlement by yourself if you feel comfortable asking the creditor to settle your debt.

Professional organizations can also deal with lenders and collection agencies on your behalf. You might prefer this option if you’re trying to settle a large amount or prefer expert help as the average settlement takes between 24 and 48 months.

Of course, debt relief agencies charge a fee for their service, increasing your debt payoff cost. Therefore, you may consider contacting the lender first to discuss your relief options before deciding if it’s worth going with an agency.

Whether you pursue DIY debt settlement or hire professional debt relief, be sure to review the settlement offer.

Verify this offer lists the financial and credit implications to avoid potential lawsuits, fees, and unexpected credit report events.

How to choose a debt settlement company

There are plenty of debt settlement companies to choose from. Following these steps can help you find the best one.

Review Accreditations

Only choose debt relief companies that are state-licensed for your state. You may also make sure they have accreditations from these bodies:

Hiring an accredited company with many years of experience is one of the easiest ways to avoid debt relief scams. You can also read customer complaints and learn about government actions.

As you compare companies and read customer reviews, consider that debt relief can be an ugly business. Even the legit companies make mistakes or don’t act as quickly as the customer desires. Thankfully, the highest-rated ones can have better success rates.

Repayment Strategy

Make sure you understand the repayment schedule, the settlement company’s services, and corresponding fees.

Your prospective debt settlement company should provide these details:

  • Written policies that are easy-to-understand
  • Transparent fees and expenses
  • Monthly payment amount
  • Estimated debt payoff timeline
  • Savings goal before requesting debt forgiveness

Verify you can afford the monthly payment or you may not be eligible for certain negotiation benefits, such as lawyer assistance if the creditor files a lawsuit.

Make sure their proposal doesn’t sound too good to be true. For example, a debt relief company may promise significant savings while quotes from two other agencies are smaller yet similar to one another.

Depending on how many accounts you’re trying to settle, the agency may attempt to resolve smaller balances approximately six months after enrolling in a plan — if you have sufficient funds.

Compare Fees

Hiring a debt settlement company isn’t cheap and you should understand the fee structure.

Current laws prohibit debt settlement programs from charging upfront fees. Instead, they usually collect a percentage of your debt payment after a successful negotiation.

Expect the fee to be between 15% and 25% of your settled debt. The precise fees vary by state as well.

For example, the fees can be between $3,000 (15%) and $5,000 (25%) with a final settlement of $20,000. In this instance, your escrow account may likely need a balance of at least $20,000 before the agency requests settlement.

Once again, an agency can’t legally collect fees until you settle debt, according to the Federal Trade Commission (FTC).

The fee amounts can vary widely, so it’s wise to speak with at least two or three companies before signing an agreement.  

In addition to the debt settlement fees, your lender will likely charge late payment fees and interest until you settle.

These fees can be expensive and erode your monthly debt contribution. As a result, it can take several additional months to reach your savings target before the agency contacts your creditor.

If the fees are too high, consider paying off your debt yourself or choosing a different debt payment strategy.

Minimum Debt Amount

It’s not uncommon for agencies to require at least $10,000 in debt to work with them. The average settlement amount is approximately $25,000 so meeting this minimum isn’t difficult for many.

You may need to settle your own debt or pursue other debt relief methods if you have a small balance.

Review Drop-Out Policy

It’s also fair to ask the company how many enrollees drop out of their relief plan before reaching a settlement.

Determine the potential penalties and fees if you don’t successfully settle a debt.

Debt Settlement Companies

You might consider these three companies as they are state-licensed and BBB accredited.

Freedom Debt Relief

Freedom Debt Relief has an “A” BBB rating and operates in most states. New Jersey is one of the few exceptions where no services are available.

You can request a free debt settlement evaluation and won’t pay any fees until the creditor offers a settlement agreement.

After enrolling in a plan, you begin making contributions. You also have complimentary access to debt lawyers by making the minimum deposits for your program.

National Debt Relief

National Debt Relief has an “A+” BBB rating and provides several debt hardship options.

Their signature debt settlement program collects a single monthly payment which deposits into a Dedicated Savings Account. You won’t pay any fees until you agree to settle a particular debt.

A free consultation will review the best repayment plan for your circumstances.

InCharge Debt Solutions

InCharge Debt Solutions has an “A+” BBB rating and is a nonprofit debt relief company. It offers different repayment and debt forgiveness solutions than Freedom Debt Relief and National Debt Relief.

Instead of specializing in debt settlement, they offer credit counseling and debt management plans which may reduce your interest rate or monthly payment.

One form of debt settlement that InCharge offers is partial credit card debt forgiveness. The company states that the average customer can pay off their credit card balances within 36 months.

Consider this company if you want free credit counseling or your debt situation isn’t a good fit for traditional debt settlement. While you pay upfront fees for select services, your total out-of-pocket costs can be lower.

FAQs about debt settlement

These questions can help you decide if debt settlement is your best option.

How bad does debt settlement hurt your credit?

Debt settlement impacts each person’s credit score differently. However, it will negatively affect you as you voluntarily stop making monthly debt payments which can flag your accounts as delinquent.

Your current credit history and the length of your credit settlement plan are also contributing factors.

Even after making a final lump-sum payment, the settled account usually remains on your credit report for seven years. The seven-year limit is either from the original date your account becomes delinquent or (if the account is in good standing) the settlement date, says Experian.

Your settled accounts also notate that the final payoff was for a smaller amount which can also have a negative effect from future lenders. Thankfully, your score can increase as your account balance is paid off and can no longer record missed payments.

How long does debt settlement take?

Most debt settlements take between 2-4 years to renegotiate every debt. Smaller balances can qualify for settling in as little as 4-6 months after signing up for a service.

The estimated timeline depends on these three factors:

  • Starting debt balance
  • Initial savings balance
  • Monthly payment amount

Your settlement plan may finish sooner if you have more cash reserves. One example can be taking out a 401(k) loan or selling off pricey assets and transferring the proceeds to your debt payoff account.

Agencies periodically contact creditors once your savings balance reaches the necessary amount where the settlement company believes they can offer an acceptable lump-sum payment.

Is debt settlement bad?

Debt settlement can reduce your lifetime repayment costs if you’re currently making the minimum monthly payment for high-interest debt. Many consider debt settlement an option of last resort before personal bankruptcy.

However, there are several alternatives you may try first that can be less risky or fee-heavy.

Some of the potential debt settlement downsides include:

  • Hurts credit score: This strategy almost always requires you to stop making your monthly loan and credit card payments before requesting settlement. The reason why is that creditors are less likely to accept a settlement if you’re still making on-time payments.
  • Few legal protections: A legit debt settlement company provides access to a debt lawyer to help avoid credit mistakes. However, you can be subject to lawsuits and wage garnishments.
  • Expensive fees: Your debt settlement plan fees are between 15% and 25% of the settlement amount. Your forgiven debt balance is also subject to taxation.
  • Takes several years: If you have a high debt balance, it can take several years to pay off these accounts. Other debt repayment alternatives can require less time and can also protect your credit.
  • Some debts don’t qualify: Secured debts and other loan types aren’t eligible for debt settlement. As a result, you must still continue making your monthly payments or explore other debt forgiveness options.

How much does debt settlement cost?

Debt settlement companies typically charge a fee that’s between 15% and 25% of your settled amount. This premium deducts from your savings account balance when you agree to a settlement offer.

Current federal laws prohibit debt settlement plans from charging setup fees or monthly fees until you agree to settle a debt. So, theoretically, you won’t pay any charges to the relief company if they don’t successfully negotiate a lower balance.

In addition to the settlement fees, there are two “hidden costs” you may encounter:

  • Late fees and interest: Creditors continue charging missed payment fees and interest charges even if you stop making payments. These fees add to your remaining balance and can require a higher savings balance before you can request forgiveness.
  • Taxes on forgiven debt: Your lender will mail tax form 1099-C (Cancellation of Debt) on your settled debt. When filing your federal income tax return, the forgiven amount is subject to income taxes just like your earned income.

How to avoid getting scammed

Common debt settlement scams can include the following.

Pay upfront fees

Legit settlement companies cannot charge for their service until they successfully settle your debt and reduce your outstanding balance.

However, other debt counseling programs can charge setup and recurring monthly fees.

Promise no legal action from creditors or collections

Only personal bankruptcy can prevent lawsuits and wage garnishments. After your accounts become delinquent during debt settlement, the creditor may sell your debt to a collection agency that may pursue legal action to recoup payment.

Your debt settlement company should help you avoid legal ramifications while negotiating a settlement.

Before enrolling, the agency should also cover the potential risks to your credit and finances.

Alternatives to Debt Settlement

You may explore these debt repayment options first as they can be safer for your finances and credit score.


Obtaining a debt consolidation loan can combine multiple accounts into a single monthly payment. Your principal doesn’t reduce, but it’s possible to qualify for a lower interest rate.

You may pay a loan origination fee but your total costs can be lower than the 15-25% premium for debt settlement.

Nonprofit Credit Counseling

Credit counseling can be free and reviews several ways to repay your debt with minimal credit and legal penalties. In addition, this hands-on service can help you make a spending plan to pay your living expenses while getting out of debt.

Debt Management Plan

A debt management plan is similar to debt settlement as you use a third party to coordinate payments and potentially get out of debt sooner.

However, instead of seeking debt forgiveness, this plan strives to reduce your ongoing interest rate and fees. You will also continue making your monthly debt payments on time to protect your credit and avoid lawsuits.

Additionally, it can take up to five years (instead of 2-4 years) and you pay monthly fees instead of a lump-sum commission for each successful negotiation.