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What is Debt Settlement?

There are two types of debt settlement: professional debt settlement and do-it-yourself (DIY) debt settlement. Let’s take a quick look at the two types:

DIY settlement does not involve a third-party firm representing you. It could involve a third-party representing the creditor. This “do it yourself” version is considered to be a less expensive form of debt settlement. It occurs when you negotiate directly with a creditor and they agree to consider your account paid for less than you owe. Creditor willingness to accept DIY settlement prior to charge-off is limited. DIY settlement following charge-off could involve a third-party representing the creditor, like a law firm, collection agency, or debt buyer. DIY settlement, while cheaper to the consumer, comes with all of the credit score damage of professional debt settlement. If you pursue DIY settlement, be sure to get the settlement agreement in writing before you pay the creditor a lump sum.

The rest of the article applies mostly to professional debt settlement. As we explain below, we do not recommend professional debt settlement under any circumstances.

Professional debt settlement is generally considered to be a risky and ill-advised debt repayment scheme. In the scheme, you avoid paying your debts. Instead, you send payments to a debt settlement firm. The firm then attempts to negotiate settlements with your creditors. The goal is to receive a “principal reduction,” which occurs when a creditor considers your debt satisfied even if you pay less than the full amount due.

If you choose to pursue it, you would start by contacting a debt settlement firm to understand their process.

How much does it cost?

The fees charged by a debt settlement firm may vary depending on your state’s laws. You can expect the firm to charge you between 15 and 25 percent of the enrolled debt. So, if you have a $10,000 debt that you settle for $5,000, you may also owe the firm $2,500 (25% of the enrolled $10,000.) in 2010 the FTC banned “advance” fees, so now debt settlement agencies cannot charge you before they render services. (insert link to the protections)

Forgiven debt is considered taxable by the IRS if over $600. This means you will likely owe taxes on the difference between the amount you owe and the amount you agree to pay. If you settled that $10,000 debt for $5,000, then $5,000 was forgiven. That $5,000 is likely to be taxable income, that will have to be reported on your income taxes.

How long does it take?

The debt settlement process typically takes three-to-four years. First, you have to put ample funds into the settlement account. Then, the settlement firm has to negotiate multiple agreements with your various creditors, which can take significant time.

How does it work?

Debt settlement is built around the idea that if you do not make your payments, creditors will be happy to accept less than the full amount due. So, you avoid paying your debts directly, and you make payments to the settlement firm. The settlement firm then pays your creditor (assuming they negotiate a settlement). There are two types of settlement they may negotiate. In a lump sum settlement, the firm makes one large payment to the creditor. In a term settlement, the firm makes multiple payments to the creditor over a period of time.

Usually, debt settlement is only used for credit card debt, but some agencies may market settlement services for other debts, like student loans, medical bills, back taxes or other unsecured debts.

Several major problems with debt settlement:


You have to intentionally not pay your debts so they will become delinquent. This will likely lead to debt collection or a lawsuit against you. If the lawsuit is successful, the creditor will obtain a judgment and may garnish your wages.


If you have multiple debts, then the firm will have to negotiate with multiple creditors. They may not reach a settlement agreement with all of your creditors, which can make your situation even more complicated. Data has shown that fewer than 10 percent of consumers are able to settle all of their debts when using a settlement firm.


Debt settlement has proven to be ineffective, and the success rates are very low. A recent study from the American Fair Credit Council (the debt settlement trade organization) found that clients only settle 43 percent of their accounts by month 36 of the process. This means that you may only be able to settle with fewer than half of your creditors. Additionally, the study found that debt settlement clients end up paying more than 78 percent of their original balance due. This means that you would only be getting a 22 percent discount on your debt, and after factoring in the tax consequences your total “savings” will be even lower.

Some major credit card companies refuse to work with debt settlement agencies. If you have debt with these creditors, then debt settlement will not be an option.

How Debt Settlement Impacts Your Credit Score

Debt settlement first requires you to avoid paying debts. This makes your debts “delinquent.” Delinquencies are listed on your credit report and damage your credit score. The impact from this will be significant in most cases. The Center for Responsible Lending once predicted that a debt settlement client’s credit score would drop 60 to 100 points. We estimate that the drop in credit score exceeds 100 points in most cases.

For more information about other debt repayment options check out our Ultimate Debt Relief Comparison White Paper.

NFCC credit counselors are nonprofit. To talk with one to discuss your options for debt relief, take a minute to schedule an appointment today! They will review your overall financial situation so that they can make the best recommendation for your repayment options with your best interest in mind.